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U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934

FOR THE FISCAL YEAR ENDED JANUARY 1, 2005

Commission file number 0-14800

X-RITE, INCORPORATED

(Name of registrant as specified in charter)

3100 44th Street S.W., Grandville, Michigan 49418

(Address of principal executive offices)

616-534-7663

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: (none)

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.10 per share

(Title of Class)

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 (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of 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. x

Indicate by checkmark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x  No ¨

On March 1, 2005, the number of shares of the registrant’s common stock, par value $.10 per share outstanding was 21,038,769.

The aggregate market value of the common stock held by non-affiliates of the registrant (i.e., excluding shares held by executive officers, directors and control persons as defined in Rule 405, 17 CFR 230.405) as of the last business day of the second quarter of the Company’s fiscal year was $293,217,267 computed at the closing price on that date.

Portions of the Company’s Proxy Statement for the 2005 Annual Meeting of Shareholders are incorporated by reference into Part III. Exhibit Index is located at Page 54.

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FORM 10-K

X-Rite, Incorporated

For The Year-Ended January 1, 2005

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Our internet website is www.xrite.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to section 13(a) or 15(d) of the Exchange Act are available free of charge through our website as soon as reasonably practicable after we electronically file with or furnish them to the Securities and Exchange Commission.

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PART I

X-Rite, Incorporated (“X-Rite” the “Company” “we” or “us”) is a color systems company that develops, manufactures, markets and supports a wide range of hardware, software and services that measures, communicates, and simulates color. Our principal products are proprietary, end-to-end solutions that utilize advanced optical and electronic sensing instruments and complimentary software. The markets served include Graphic Arts, Retail, and Industrial. A more detailed discussion of X-Rite products and markets appears below.

X-Rite was organized in 1958 as a Michigan corporation and made its initial public offering of common stock in April of 1986. We have grown through internal expansion and acquisitions, investing heavily over the past two years in our core color businesses.

We introduced 7 new products and 10 major product upgrades and devoted substantial resources to research, development, and engineering in 2004. We currently spend over 12 percent of our revenues annually on engineering, research, and development. Our focus continues to center on color management solutions that incorporate software, hardware, and services.

With offices in ten countries, service centers across Europe, Asia, and the Americas, X-Rite continues to improve its ability to conduct business with customers around the world. In 2004, international sales represented 47 percent of total revenue. The Company began to accelerate its global presence in 1993 with the establishment of two foreign sales and service subsidiaries: X-Rite GmbH, Cologne, Germany and X-Rite Asia-Pacific Limited, Hong Kong. In 1994, we established a U.K. subsidiary, X-Rite, Ltd., which acquired the outstanding stock of an X-Rite dealer located near Manchester, England. In 1998, a French subsidiary, X-Rite Méditerranée SARL, was established by acquiring a branch of an X-Rite dealer located near Paris. 2002 marked the opening of X-Rite, (Shanghai) International Trading Co. Ltd., a sales and service center incorporated in The Peoples Republic of China. This subsidiary coordinates activity with previously opened representative offices in Beijing, Tianjin and Guangzhou strengthening our ability to serve China’s growing markets. In 2003, we affirmed our commitment to Japan and the many multi-national headquartered companies that reside there by expanding our sales office and creating a new company, X-Rite, K.K.

We completed four acquisitions in 2003 and 2004, (see Note 9 to the Consolidated Financial Statements).

Monaco Systems, Inc. - a company that develops and distributes color management software in the graphic arts and photo markets. Monaco’s products provide the Company with color management software solutions, broadening its ability to serve new and existing customers.

ccDot meter product line of Centurfax Ltd. - expanding its computer-to-plate product lines for the pre-press and printing industries to include the printing of flexible plastics and corrugated products.

ColoRx ^® product line and related assets of Thermo Electron Corporation - a former supplier of color measurement equipment to a large paint manufacturer and distributor, enabling X-Rite to enter into a five-year agreement with Benjamin Moore & Co. to be the preferred provider of color management solutions to its authorized dealers.

Moniga Gremmo – an industrial and ink formulation software company, based in Milan, Italy. This product acquisition extends X-Rite’s color quality control software capabilities with specific features commonly used in industrial markets such as inks, paints, plastics, textiles, cosmetics, and foods.

We operate in one segment: quality control instruments and accessories. Accordingly, no separate operating segment information is presented.

Our primary market focus is in the color management and measurement area. We provide end-to-end solutions that combine hardware, software, and services to customers in three major markets.

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MAJOR MARKETS

Graphic Arts

The Graphic Arts business represented approximately 44 percent of X-Rite’s total net sales in 2004, and consists of two major markets: Digital Imaging and Printing.

X-Rite’s Digital Imaging markets consist of on-demand print-for-pay, photo processing, photography, graphic design, pre-press service bureaus, and a myriad of calibration tools for image setters, raster image processors, and digital printers. Our product solutions work to create value at key stages of the graphic arts workflow by reducing waste and increasing productivity.

The primary Printing markets that we serve are in commercial printing and package printing. X-Rite’s color-calibrated instruments, digital palettes, and output measurement devices support color communication for the entire printing and preprinting process eliminating costly mistakes. Our handheld products are straightforward, self-contained solutions that keep color on-target in the pre-press process, ink lab and the pressroom. X-Rite’s automated scanning systems support the need for faster and more frequent color data collection.

Retail

X-Rite’s Retail business serves two major markets: paint matching and home décor. This business is conducted under the name of Match Rite and represented approximately 17 percent of our total net sales in 2004. X-Rite is the leading supplier of retail paint matching systems for home centers, mass merchants, hardware stores and paint retailers in North America, and it has established a strong presence in Europe and other regions of the world. X-Rite’s Retail customers rely on its strength in color measurement instrumentation, database creation and management, custom software development, and large scale account servicing. These solution-based products reduce paint inventory for the retailer and provide a user-friendly environment promoting sophisticated shade matching capabilities for the consumer. We are leveraging our retail-based expertise to broaden this market and develop other shade matching applications for our retail customer base.

Industrial

Our Industrial business represented approximately 26 percent of total net sales in 2004, and is concentrated in the automotive and process control markets. We design, develop, and manufacture reliable and accurate precision instrumentation for global manufacturers fulfilling a need to measure color for formulation, quality, and process control for paint, plastics, and textiles. Accurate color reproduction offers businesses a competitive advantage, and is an important factor when products are assembled from parts made around the world. X-Rite industrial product solutions are designed to reduce waste, increase production uptime, improve process management, and enable global color communication.

Other

Light measurement – X-Rite is one of the most experienced suppliers of light measurement technology in the world, producing best-in-class light measurement systems and accessories, uniform light sources, diffuse reflectance materials, and reflectance standards. Our Labsphere subsidiary specializes in the design and manufacture of integrating spheres and systems, and instruments for a variety of electro-optical test and measurement applications, including: lamp flux measurement, LED measurement, reflectance and transmittance measurement, and radiance and irradiance applications. This extensive product line features more than 100 systems and accessories that serve many industries, including telecommunications, automotive, and military/aerospace

Medical and Dental – X-Rite serves the medical x-ray market’s imaging needs and provides instrumentation designed for use in controlling variables in the processing of x-ray film. Additionally, we manufacture restorative tooth shade matching instruments and complementary software packages that are designed for use in cosmetic dental practices. Our ShadeVision^® System is a significant technological advance that improves patient care by replacing the subjective selection of tooth color with an accurate measurement. This product line is sold and marketed exclusively through our partner, Sullivan-Schein Dental, part of the Henry Schein Company.

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PRODUCTS

X-Rite’s color measurement solutions are comprised of hardware, software, and services. Here is a brief overview of the primary components that make up our product lines.

Instrumentation

Software

The Company provides software that interacts with its color measurement instruments and other process equipment. These software packages allow the user to collect and store color measurement data, compare that data to established standards, and communicate color results and formulate colors from a database.

OTHER INFORMATION

Manufacturing, Sourcing and Service

We manufacture the majority of our products at the manufacturing facility in Grandville, Michigan. We generally have multiple sources for raw materials, supplies and components, and are generally able to acquire materials on a volume discount basis. We provide product repairs and service at ten locations throughout the world.

Competition

The color management and measurement business is intensely competitive and subject to technological change, evolving customer requirements, and changing business models. We face significant competition in all areas of our current business activities. The rapid pace of technological change continually creates new opportunities for existing competitors and start-ups and can quickly render existing technologies less valuable. Customer requirements and preferences continually change as other technologies emerge or become less expensive. We face direct competition with approximately 12 firms producing competing products in the graphic arts category, and approximately six manufacturers of competing products in the retail and industrial markets some of whom have significant resources and sales. The primary basis of competition for all the Company’s products is technology, design, service, and price. Our competitive position may be adversely affected in the future by one or more of the factors described in this section.

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Employees

As of March 1, 2005, the Company employed 643 people on a full time basis, of which 509 are in the United States. We believe we have been successful in attracting and retaining highly qualified employees, but we cannot guarantee that we will continue to be successful in the future. We believe we have good relationships with our employees.

Patents

X-Rite owns 63 patents and currently has 43 patent applications on file. While the Company follows a policy of obtaining patent protection for its products where appropriate, it does not believe that the loss of any existing patent, or failure to obtain any new patents, would have a material adverse impact on its current operations. We expect to protect our products and technology by asserting our intellectual property rights where appropriate and prudent.

Distribution Networks

X-Rite’s products are sold by its own sales personnel and through independent manufacturer’s representatives. Certain products not sold directly to end-users are distributed through a network of independent dealers in eighty countries. Independent dealers are managed and serviced by the Company’s sales staff and by independent sales representatives.

Seasonality

The Company’s business is generally not subject to seasonal variations that significantly impact sales, production, or net income.

Working Capital Practices

The Company does not believe that it or the industry in general, has any special practices or special conditions affecting working capital items that are significant for an understanding of the Company’s business.

Significant Customers

No single customer accounted for more than 10 percent of total net sales in 2004, 2003, or 2002. We do not believe that the loss of any single customer would have a material adverse effect on the Company.

Backlog

The Company’s backlog of scheduled but unshipped orders was $4.6 million at February 28, 2005, and $5.3 million at February 29, 2004. This backlog is expected to be filled during the current fiscal year.

Research, Development and Engineering

During 2004, 2003, and 2002, respectively, the Company expensed $15.2, $14.6, and $12.4 million on research, development, and engineering. X-Rite has no customer sponsored research and development activities.

See Note 1 to the consolidated financial statements contained in Part II, Item 8 of this report for a discussion of our domestic and international sales.

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The Company and its subsidiaries own or lease properties throughout the world. Listed below are the principal properties owned or leased as of March 1, 2005:

Collectively, X-Rite and its subsidiaries own approximately 288,000 square feet of space and lease approximately 65,000 square feet. Management considers all the Company’s properties and equipment to be suitable and adequate for its current and reasonably anticipated development, production, distribution, and selling requirements.

The Company is periodically involved in other legal proceedings, legal actions, and claims arising in the normal course of business, including proceedings related to product, labor, and other matters. Such matters are subject to many uncertainties, and outcomes are not predictable. The Company records amounts for losses that are deemed probable and subject to reasonable estimate. We do not believe that the ultimate resolution of any of these matters will have a material adverse effect on its financial statements.

No matters were submitted to a vote of security holders during the fourth quarter of the year ended January 1, 2005.

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EXECUTIVE OFFICERS OF THE REGISTRANT

The following table lists the names, ages, and positions of all of the Company’s executive officers. Except as discussed, each of the named officers has served the Company in an executive capacity for more than five years.

Mr. Ferrara was appointed President of X-Rite, Incorporated in 2001, and Chief Executive Officer in 2003.

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PART II

The Company’s common stock is quoted in the NASDAQ – National Market System under the symbol XRIT. As of March 1, 2005, there were approximately 1,300 shareholders of record. Ranges of high and low sales prices reported by The NASDAQ National Market System for the past two fiscal years appear in the following table.

The Board of Directors intends to continue paying dividends at the current quarterly rate of 2.5 cents per share. The Board of Directors re-evaluates the Company’s dividend policy periodically. Any determination relating to the Company’s dividend policy will be at the discretion of the Board of Directors and will be dependent upon a number of factors including the Company’s financial condition, results of operations, capital requirements, terms of the Company’s financing arrangements and such other factors as the Board of Directors deems relevant.

Selected financial data for the five years ended January 1, 2005 is summarized as follows:

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FORWARD-LOOKING STATEMENTS:

This discussion and analysis of financial condition and results of operations, as well as other sections of the Company’s Form 10-K, contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act, as amended, that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the industries it serves, the economy, and about the Company itself. Words such as “anticipates,” “believes,” “estimates,” “expects,” “likely,” “plans,” “projects,” “should,” variations of such words and similar expressions are intended to identify such forward looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties, and assumptions that are difficult to predict with regard to timing, extent, likelihood, and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. Furthermore, X-Rite, Incorporated undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements include, but are not limited to statements concerning liquidity, capital resources needs, tax rates dividends, and potential new markets.

The following discussion and analysis describes the principal factors affecting the results of operations, liquidity, and capital resources, as well as the critical accounting policies, of X-Rite, Incorporated (also referred to as “we” “us” “X-Rite” and “the Company”). This discussion should be read in conjunction with the accompanying audited financial statements, which include additional information about the Company’s significant accounting policies and practices and the transactions that underlie its financial results.

Company Business

We are a color systems company that develops, manufactures, markets and supports a wide range of hardware, software and services that measures, communicates, and simulates color. Our principal products are proprietary, end-to-end solutions that utilize advanced optical and electronic sensing instruments and complementary software. The key markets served include Graphic Arts, Retail, and Industrial.

We generate revenue by selling products and services through a direct sales force as well as select distributors. The Company has sales and service facilities located in the United States, Europe, Asia, and Latin America.

Our cost of sales consists primarily of the costs associated with manufacturing its products. Those costs consist of materials, labor and manufacturing overhead. X-Rite’s primary manufacturing activities are conducted at facilities in Michigan and New Hampshire. Software development is conducted at these facilities, as well as one in Massachusetts. X-Rite’s gross profit historically has fluctuated within a relatively narrow range. Principal drivers of gross profit include production volumes, product mix, labor, facilities and materials costs.

Operating expenses are composed of three categories; selling and marketing, general and administrative expenses and research, development and engineering. Selling and marketing expenses consist of wages, commissions, facility costs, travel, advertising, media and product promotion costs. General and administrative expenses include compensation and facilities costs for the information systems, executive, human resources and finance departments, as well as software, legal and consulting costs. Research, development and engineering expenses are composed of wages, facilities, software and consulting costs. These costs are incurred for both new product development, and the support and refinement of the existing product lines.

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Overview of 2004

In 2004, we delivered revenue, operating income and net income improvement over our 2003 results. Highlights of 2004 include:

Throughout 2004, we took a number of specific steps to build our color business and strengthen our Company. Specifically:

As we look forward, we believe customer demand for color related solutions will continue to grow. We are focused on developing the innovative products and solutions that our customers demand and executing our business strategies.

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Results of Operations

The following table sets forth information derived from the Company’s consolidated statements of operations and includes amounts expressed as a percentage of net sales. (in thousands)

The following tables contain various non-GAAP (Generally Accepted Accounting Principles) financial measures. A “non-GAAP financial measure” is defined as a numerical measure of a company’s financial performance that excludes or includes amounts so as to be different than the most directly comparable measure calculated and presented in accordance with GAAP in the Consolidated Statements of Operations, Balance Sheets or Statements of Cash Flows of the Company. Pursuant to the requirements of Regulation G, each non-GAAP measure (those measures excluding specific items) is immediately preceded with the most directly comparable GAAP measure, and the difference in all cases is the exclusion of items the Company considers “non-recurring” due to their nature, size or infrequency. Those items included as specific items are discussed in several sections of this discussion and analysis. Each non-GAAP financial measure is presented because we monitor our business using this information, and we believe that it gives a more meaningful comparison of the results of our core business operations.

Operating income excluding specific items (in thousands)

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Income (loss) before income taxes excluding specific items (in thousands)

Net Sales

Net sales in 2004 were $126.2 million, compared to $117.1 million in 2003, an increase of $9.1 million or 7.8 percent. We achieved sales records on both an annual and quarterly basis. Our fourth quarter sales of $38.8 million were our tenth consecutive quarter of comparable period growth. Sales in 2002 were $98.5 million. The sales growth in 2004 is attributable primarily to internal growth and the positive effect of foreign exchange rates. Internal growth in 2004 was $6.2 million which was driven in part by the successful integration of the 2003 acquisitions in the Graphics Arts (cc Dot, now known as X-Rite Dot and Monaco Systems) and Retail product lines (Benjamin Moore), as well new product introductions. Favorable foreign exchange rates, primarily the Euro and Pound Sterling also contributed $2.8 million of the year over year gain in 2004. The following table highlights the contributions of each of these factors to 2004 sales and compares them to the prior two years:

Elements of Sales Growth (in millions)

X-Rite’s provides color measurement solutions to many industries which we measure in five separate product lines, Graphic Arts, Industrial, Retail, Light and Other. The following table denotes sales by product line for the past three years

Sales by Product Line (in millions)

Graphic Arts

The Graphics Arts product lines provide product solutions to the commercial and package printing industries as well as the on demand print, photo processing, photography, graphic design and pre-press service bureaus in the imaging industries. Combined Graphic Arts sales in 2004 were $54.8 million, compared to $52.4 million in 2003, an increase of $2.4 million or 4.6 percent. Approximately $1.2 million of the 2004 increase is attributable to foreign exchange rates. Graphic Arts sales in 2002 were $41.7 million.

Printing sales contributed almost all of the gains in Graphic Arts in 2004, recording sales of $28.1 million compared to $25.7 million in 2003, an increase of $2.4 million or 9.3 percent. Our growth was driven by strong scanning system sales, general improvement in the printing market and full year sales of the X-Rite Dot product. Growth in excess of 20 percent was noted in all of our key geographic markets except North America which was flat. Printing sales in 2002 were $21.3 million.

Imaging sales in 2004 and 2003 were $26.7 million. Sales were negatively impacted by sluggishness in the photo mini lab business and delays in shipping two new products. Imaging sales in Asia Pacific grew 55 percent in 2004, while Europe and North American sales declined 2.6 and 6.9 percent respectively.

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Industrial

The Industrial products group provides color measurement solutions for the automotive and process control markets. Our products are integral part of the manufacturing process for automotive interiors and exteriors, as well as the refinishing and non-automotive secondary markets. In 2004, the Industrial product lines recorded sales of $32.2 million, compared to $27.2 million in 2003, an increase of $5.0 million, or 18.4 percent. Industrial sales were $23.0 million in 2002. Foreign exchange gains primarily in Europe provided $1.1 million of the Industrial sales gain in 2004. Much of growth in 2004 occurred outside our core North American market. The expanding manufacturing economy in China as well as the growth in consumer spending there led to a 54.6 percent growth in the Asia Pacific region as compared to 2003. Foreign exchange rates have a nominal effect on our sales results in the Asia Pacific region. Favorable foreign exchange rates and growth in our core markets caused sales in Europe to grow 25.4 percent in 2004 as compared to 2003. Foreign exchange rate changes provided approximately fifty percent of the European gains in 2004. Sales in North America grew at only a 1.0 percent pace in 2004, due to primarily to reduced capital spending in the auto markets.

Retail

The Retail products group markets its paint matching and home décor product lines under the Match-Rite label to home improvement centers, mass merchants and paint retailers. In 2004, Retail sales were $20.9 million compared to $17.9 million in 2003, an increase of $3.0 million or 16.8 percent. Sales in 2002 were $14.7 million. Growth in sales in 2004 is attributable to new products and upgrades as well as continued strength and demand with our large retail customers. Foreign exchange rates had a nominal effect on sales in 2004 as over 90 percent of sales are in North America.

Light

X-Rite serves the light measurement market primarily through its Labsphere subsidiary. Labsphere provides integrating spheres and systems as well as reflectance materials used for an array of measurement and processing applications. Light sales in 2004 were $11.9 million compared to $12.4 million in 2003, a decrease of $0.5 million, or 4.0 percent. Foreign exchange rates provided a benefit of $0.3 million in 2004 as compared to 2003. Sales in 2002 were $11.9 million. Demand for light products has remained sluggish due to continued softness in the LED and telecommunications industries. We have seen slight improvements in the market during the latter half of 2004 and anticipate modest improvements in 2005.

Other

The Company’s product lines denoted as Other generally provide products and services to the medical and dental industries. Total sales of these products in 2004 were $6.4 million compared to $7.2 million in 2003, a decrease of $0.8 million, or 11.1 percent. Sales for 2002 were $6.9 million. Foreign exchange rates had a nominal effect on sales for these groups.

Our medical products provide instrumentation designed for use in controlling variables in the processing of x-ray film. Medical product sales were $4.1 million in 2004, compared $4.0 million in 2003, an increase of $0.1 million or 2.5 percent. Sales in 2002 were $3.9 million.

The dental products line provides color-matching technology to the cosmetic dental industry through our ShadeVision systems. Effective in 2004, Sullivan-Schein, Inc. assumed all sales and marketing responsibilities for the ShadeVision product line with X-Rite continuing its manufacturing and development role. This agreement was expected initially to lower total sales and margins as well as sales administrative and development expenses. Sullivan-Schein is a world-leading provider of products and services to the dental industry. Dental product sales in 2004 were $2.3 million compared to $3.2 million in 2003, a decrease of $0.9 million, or 28.1 percent. Sales for 2002 were $3.1 million.

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Sales by Region Served

Sales growth in 2004 was accomplished primarily in our international markets. Sales to the Asia Pacific and European markets grew 31.6 and 9.7 percent respectively. Sales in Europe, which are denominated primarily in the Euro and Pound Sterling, continued to benefit in 2004 from the weak U.S. dollar. Growth in the Asia Pacific region was driven mainly by organic growth and the increasing manufacturing base in China. Foreign exchange rates have had a nominal effect in this region, as most of our sales are denominated in U.S. dollars or currencies pegged to the dollar. Latin America, which is the Company’s smallest market, grew by 17.9 percent in 2004.

The following table highlights the Company’s growth by region over the past three years.

Sales by Geographic Region (in millions)

Price changes had a marginal impact on sales levels over the past three years.

Gross Profit

Gross profit as a percent of net sales increased slightly in 2004, to 64.4 percent as compared to 63.8 and 62.5 percent in 2003 and 2002, respectively. Margins have remained strong in our core color products line for the past several years, while the light and medical products have been significantly below the Company average. The medical products margins have been impacted by the change in the Sullivan Schein marketing arrangement, while the light products margin have suffered from continued soft sales. On a consolidated basis, we have been able to maintain a strong margin with slight increases for the past several years due to the following factors:

The combination of increased sales volumes and favorable foreign exchange rates allowed for higher absorption of factory overhead costs and increased profitability on certain foreign sales, as the underlying product cost was denominated in U.S. dollars. Our increased emphasis on total color product solutions has altered the product mix to include larger software and service components which typically produce higher margins. We expect software to continue to grow as a proportion of total sales.

Operating Expenses Overview

Total operating expenses were $65.5, $66.0, and $55.1 million for 2004, 2003, and 2002 respectively. The year over year decrease in 2004 was $0.5 million or 0.8 percent. In 2003, the Company recorded Goodwill and other long-lived impairment charges of $2.6 million and received a one-time payment of $1.0 million for the reimbursement of expenses in connection with renegotiation of a customer supply agreement, which was classified as a reduction of general and administrative expenses, thereby lowering that line item. After adjusting for these transactions, 2003 operating expenses would have been $64.4 million and 2004 operating expenses were $1.1 million or 1.7 percent higher than the 2003 adjusted amount.

Changes in foreign exchange rates accounted for $1.2 and $1.7 million of additional operating expenses for the 2004 and 2003, respectively, as compared to prior years.

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Selling and Marketing Expenses

Selling and marketing expenses consist primarily of compensation, facility costs, travel, advertising and trade show expenses associated with the Company’s global sales and marketing personnel. Selling and marketing expenses were $33.5 million for 2004, compared to $31.5 million in 2003, an increase of $2.0 million or 6.3 percent. This increase reflects higher commissions and incentive costs, unfavorable foreign exchange fluctuations in Europe and the reclassification in 2004 of certain costs from general and administrative. In addition, costs of $0.7 million were incurred in 2004 for the DRUPA Graphic Arts trade show, which is held in Germany every four years. DRUPA is the largest graphic arts trade in the world and was a focal point of the Company’s graphic arts marketing and product launch efforts in 2004.

In 2003, selling and marketing costs increased $3.7 million or 13.3 percent over 2002 costs of $27.8 million. This increase was attributable to higher compensation costs and benefit costs, increased travel costs and the effect of unfavorable foreign exchange rates in Europe. Marketing costs increased as a result of consulting expenses incurred for new product strategy and research as well as costs related to the launch of a new corporate brand identity. The increases noted in 2002 costs were across most lines of business, with particular emphasis on newer lines including ShadeVision and Coherix. Additional costs were also incurred in 2002 for new product rollouts for the 8000 Benchtop series, ColorDesigner and ATD News, and additional staffing and travel costs related to the opening of the Shanghai office.

As a percentage of net sales, selling and marketing expenses were 26.6, 26.9, and 28.2 percent in 2004, 2003, and 2002 respectively.

General and Administrative Expenses

General and Administrative costs include compensation, facility costs, and travel for the Company’s executive, finance, human resources and administrative functions. General and administrative expenses in 2004 were $16.8 million compared to $17.2 million in 2003, a decrease of $0.4 million, or 2.3 percent. The decrease was attributable primarily to severance costs incurred in 2003 of $1.4 million for the Company’s former Chief Executive and Chief Financial Officers. These costs were offset in 2004 by incremental operating costs for the Monaco Systems operations which were acquired in July of 2003, increased professional fees and unfavorable foreign exchange fluctuations. In 2003, the Company received a one-time payment of $1.0 million for the reimbursement of expenses in connection with renegotiation of a customer supply agreement, which was classified as a reduction of general and administrative expenses. After adjusting for this payment, the 2003 expenses would have been $18.2 million and the year over year decrease when compared to 2004 would have been $1.4 million or 7.7 percent.

General and administrative expenditures in 2003 were $2.2 million or 14.7 percent higher than 2002. The increases were attributable to increased compensation and benefits costs, costs related to the Monaco Systems acquisition, unfavorable foreign exchange rates in Europe and severance costs. The 2002 general and administrative costs were $0.4 million or 2.7 percent lower than 2001. This nominal decrease was primarily attributable to the positive effects of several corporate cost cutting initiatives that were focused on domestic operations.

As a percentage of net sales, general and administrative expenses were 13.3, 14.7, and 15.2 percent in 2004, 2003, and 2002 respectively.

Research, Development and Engineering Expenses

Research, Development and Engineering (RD&E) expenses include compensation, facility costs, consulting fees, and travel for the Company’s engineering staff. These costs are incurred primarily in the United States. RD&E expenditures in 2004 were $15.2 million compared to $14.6 million in 2003, an increase of $0.6 million, or 4.1 percent. Total expenditures in 2004 including capitalized software costs increased $1.0 million. Most of these costs were the incremental engineering costs associated with the Monaco Systems acquisition which occurred in July of 2003. In 2002, RD&E expenditures were $12.4 million. Due to the number of new products in planning RD&E, expenses are projected to increase on a dollar basis in the future while the total costs as a percentage of revenues are expected to remain in the range of 12 to 14 percent.

RD&E costs, as a percentage of net sales were 12.0%, 12.5%, and 12.6% for 2004, 2003 and 2002, respectively.

In addition to the RD&E costs reported as operating expenses, costs were incurred to develop new software products in each of the last three years that were capitalized. Software development costs capitalized totaled $3.3, $2.9, and $1.7 million in 2004, 2003, and 2002, respectively. The related amortization expense was included in cost of sales (see Note 2 to the Consolidated Financial Statements).

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Goodwill and Other Long Lived Asset Impairments

In December of 2003, the Company elected to exit the shape measurement business due to continued disappointing sales results and explore alternatives for its Coherix subsidiary including a possible sale. In connection with this decision, an impairment charge of $2.6 million was recorded. This charge consisted of $1.9 million of goodwill and $0.7 million of primarily other long-lived assets. On June 30, 2004, the Company sold the primary assets of Coherix for $0.8 million. Under the terms of the agreement, the purchaser received all operating assets and intellectual property of the Company. The purchaser made an initial payment of $0.1 million with the remaining balance secured by a non-interest bearing note due in installments over a six-year period. The Company will record gains on the sale as payments are received on the note. As a result, the Company has recorded a deferred gain on the balance sheet of approximately $0.5 million, representing the discounted value of the note.

Other Income (Expense)

Other Income (Expense) consists primarily of dividend and interest income, foreign currency exchange gains and losses, and interest charges in connection with the Founders’ Share Redemption Agreement. In November 2004, the Company recorded an interest credit of $0.7 million in connection with the reversal of FAS No. 150 relating to the Founders’ Shares Redemption Agreements. This amount represents the charges recorded in 2003, relating to the increase in the Founders’ Liability. Dividend payments on Founders’ Shares previously classified as interest expense were paid and thus settled while the repurchase agreements were accounted for as a liability and therefore not reversed to income. The payments were $0.3 and $0.2 million in 2004 and 2003. Foreign exchange losses in 2004 were ($0.3) million which was offset by interest and other income of $0.1 million. Net other income in 2003 was nominal.

Write-Down of Other Investments

Other investments include investments made by the Company’s strategic venture capital group, XR Ventures, LLC (XRV) (See Other Investments, for additional information). Each investment represents less than 20 percent of the ownership of the respective portfolio companies. Since the Company does not exercise significant influence over the operating and financial policies of each portfolio company, the investments have been recorded at cost.

The Company periodically evaluated the carrying value of each investment to determine whether a decline in fair value below the respective cost has occurred. If the decline is determined to be other than temporary, the carrying value is adjusted to the then current fair value and a loss is recognized. At various times in 2003 and 2002 the Company performed comprehensive assessments of the continuing value of each XR Ventures investment.

Based on the continued erosion of the venture capital markets, the technology sectors of the economy and specific reviews of its portfolio, the Company concluded that the value of its investments had been permanently impaired. Therefore, the Company recorded charges of $0.1, $0.2 and $3.4 million in March, June and December of 2003, respectively, for a total of $3.7 million for the year. The Company recorded charges of $6.6 and $0.6 million in June and December 2002, respectively, for a combined total of $7.2 million for the year. At January 3, 2004, all venture capital investments had been fully impaired. Although the Company continues to hold positions in several XR Ventures’ portfolio companies, no future investments in the remaining portfolio companies will be made, except where necessary to protect any existing investments.

In 2002 and 2001, the Company concluded that it may not be able to realize certain capital losses it incurred prior to their expiration related to these impairments. Therefore, it did not record a tax benefit at that time. In 2003, the Company re-evaluated this position and concluded that the execution of certain qualified tax strategies which the Company was capable of completing, would allow for the realization of capital gains within the expiration period. Accordingly, a tax benefit of $2.8 million was recorded in the fourth quarter of 2003 related to the prior years’ impairments.

Income Taxes

For 2004, the Company recorded an income tax provision of $3.5 million, an effective rate of 22.2 percent. The effective tax rate has benefited from the execution of certain international tax strategies and research and development tax credits. A tax benefit of $0.6 million was recorded in the third quarter of 2004 as a result of amended filings of our 2000 through 2002 tax positions related to research and development credits.

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The Company has not provided for U.S. federal income and foreign withholding taxes on undistributed earnings from non-U.S. operations as of January 1, 2005 because such earnings are intended to be reinvested indefinitely outside of the United States and certain of these entities are pass through tax entities. Where excess cash has accumulated in non-U.S. subsidiaries and it is advantageous for business operations, tax or cash reasons, subsidiary earnings would be remitted. If these earnings were distributed, foreign tax credits may become available under current law to reduce or eliminate the resulting U.S. income tax liability. The Company has not reevaluated its position with respect to the indefinite reinvestment of foreign earnings to take into account the possible election of the repatriation provisions contained in the American Jobs Creation Act of 2004. The status of this evaluation of these provisions is described in the following section.

The American Jobs Creation Act of 2004 (the “Jobs Act”), enacted on October 22, 2004, provides for a temporary 85% dividends received deduction on certain foreign earnings repatriated during a one-year period. The deduction would result in an approximate 5.25% federal tax rate on the repatriated earnings. To qualify for the deduction, the earnings must be reinvested in the United States pursuant to a domestic reinvestment plan established by a company’s chief executive officer and approved by the company’s board of directors. Certain other criteria in the Jobs Act must be satisfied as well. The Company’s one-year period during which the qualifying distributions can be made is fiscal 2005. The Company is in the process of evaluating whether it will repatriate foreign earnings under the repatriation provisions of the Jobs Act, and if so, the amount that will be repatriated. The range of reasonably possible amounts that could be repatriated, which would be eligible for the temporary deduction, has not been determined at this time, nor the impact of a qualifying repatriation, should it choose to make one, on its income tax expense for 2005, the amount of its indefinitely reinvested foreign earnings, or the amount of its deferred tax liability with respect to foreign earnings. The Company is awaiting the issuance of further regulatory guidance and passage of statutory technical corrections with respect to certain provisions in the Jobs Act prior to determining the amounts if any, it will repatriate. The Company expects to complete its evaluation to determine the amounts and sources of foreign earnings to be repatriated, if any, during the third quarter of 2005.

The Company recorded a tax benefit of $1.2 million in 2003 against pre-tax income of $5.5 million. This benefit reflects the reversal of $2.8 million in deferred tax valuation reserves established in 2002 and the first three quarters of 2003. These valuation reserves were originally recorded in connection with the write-downs of the XRV investment portfolio in 2001 and 2002. At that time, the Company was not assured that these write downs would be fully deductible capital losses and a valuation allowance was established. In the December 2003, a qualified tax strategy was put in place that would allow for the ultimate realization of capital gains within the expiration period and accordingly the valuation allowance was reversed. Exclusive of the valuation allowance reversal, the Company’s effective tax rate would have been 37 percent compared to the U.S. statutory rate of 35 percent. The increase over the statutory rate is primarily attributable to the effect of certain non-deductible foreign losses, expenses related to the adoption of SFAS 150 for the founders’ program and state income taxes.

The Company recorded a tax provision of $1.0 million in 2002 against a loss before taxes and the cumulative effective of change in accounting principle of $0.8 million. The provision was adjusted by the potential non-deductible capital losses associated with the write-down of investments by XR Ventures, LLC. Exclusive of these write-downs, the Company would have had approximately a 16 percent tax rate in 2002, compared to the U.S. statutory rate of 35 percent. This lower rate was due to tax reductions received as a result of the Company’s foreign sales operations.

Cumulative Effect of Change in Accounting Principle

Effective December 30, 2001, the Company adopted SFAS No. 142, “Goodwill, and Other Intangible Assets”. SFAS No. 142 requires companies to discontinue amortizing goodwill and certain intangible assets with an indefinite life. Instead, companies are required to review goodwill and intangible assets with an indefinite useful life for impairment annually and as indicators of impairment occur. As discussed further in Note 4 to the Consolidated Financial Statements, during 2002, the Company completed steps one and two of the transitional testing required by SFAS No. 142, as well as, the annual impairment-testing requirement. Step two testing was completed with the assistance of an independent valuation firm during the fourth quarter of 2002.

Under SFAS No.142, goodwill impairment exists if the net book value of a reporting unit exceeds its estimated fair value. The Company evaluated goodwill using three reporting units, Labsphere and Optronik combined, Coherix, and X-Rite Mediterranee.

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Upon completion of the step two transitional testing for the Labsphere and Optronik combined reporting unit, it was determined that an impairment of goodwill had occurred. Therefore, a non-cash charge of $7.6 million, or 38 cents per share, was recorded and classified as a cumulative change in accounting principle as required by SFAS No. 142 in the first quarter of 2002. The decline in fair value of the Labsphere and Optronik reporting unit was primarily attributable to a decline in revenue and profitability for the unit. This decline led to a reduction in the three to five year projection of operating earnings for the unit. The fair value of the remaining units exceeded their net book value; therefore, no impairment charges were recorded for these units. In calculating the impairment charge, the fair value of the reporting unit was determined by using a discounted cash flow analysis. This methodology was selected over the market value approach, due to a lack of comparable competitor data availability, which is necessary to complete a market value study.

Liquidity and Capital Resources

As highlighted in the Consolidated Statements of Cash Flows, our liquidity and available capital resources are impacted by four key components: (i) current cash, cash equivalents, and short-term investments, (ii) operating activities, (iii) investing activities and (iv) financing activities. Each of these components is discussed below.

Cash, Cash Equivalents and Short-Term Investments

At January 1, 2005, the Company had cash and cash equivalents of $9.7 million, compared to $10.8 million at January 3, 2004, a decrease of $1.1 million. Our short-term investment portfolio has a market value of $6.3 million at January 1, 2005, an increase of $2.9 million over January 1, 2004. Operating and financing activities provided $15.3 and $1.4 of cash in 2004, respectively. Investing activities required the use of $17.7 million in 2004, including $2.9 million net, used to acquire short-term investments. Foreign exchange rates had a nominal effect on cash flows in 2004. At January 1, 2005, $2.0 million of cash and cash equivalents were held by our subsidiaries outside of the United States.

Operating activities in 2003 generated a positive cash flow of $18.3 million, which was offset by funds used for investing and financing activities of $16.1 and $1.3 million respectively. Foreign exchange rates caused a decrease in cash of $0.2 million.

Operating Activities

Operating activities provided $15.3 million of cash during 2004 compared to $18.3 million in 2003, a decrease of $3.0 million or 16.4 percent. The 2004 operating cash flows primarily resulted from net income of $12.4 million adjusted for non-cash items of $7.0 million, which was offset by changes in other operating assets and liabilities of $4.1 million. The most significant non-cash adjustment to cash flow was $6.0 million for depreciation and amortization. Fourth quarter sales volumes drove much of the change in operating assets and liabilities, as receivables increased $4.5 million while inventory levels decreased $1.6 million as compared to 2003. Other current and non-current liabilities decreased $1.7 million in 2004, reflecting lower payouts on certain incentive compensation awards, completion of two executive severance packages and recognition of deferred revenue on the sale of the Coherix assets. This decrease was offset by $0.9 million increase in income taxes payable and $0.2 million decrease in accounts payable.

Net cash provided by operating activities was $18.3 million in 2003 compared with $14.8 million in 2002, an increase of $3.5 million, or 23.6 percent. In 2003, net cash provided by operating activities was comprised of net income of $5.5 million adjusted for non cash items of $9.9 million and net cash provided from changes in operating assets and liabilities of $2.9 million. Included in the non cash items were expenses that reduced net income but did not require the use of cash, which consisted mainly of $6.0 million for depreciation and amortization, $3.7 million associated with the write downs of XR Ventures investments, which occurred in the first, second and fourth quarters, $2.6 million related to the impairment of the Coherix assets, which was recorded in the fourth quarter and the increase in the value of shares subject to redemption agreements of $0.7 million. These adjustments were offset by an increase in deferred taxes of $4.1 million. Net cash provided by operating assets and liabilities was driven primarily by an increase in other accrued liabilities, which includes accrued payroll and benefits, income taxes and miscellaneous liabilities. The largest change in these items was for accrued compensation costs, which includes a charge of $0.7 million for severance costs and benefits for the Company’s former Chief Executive and Chief Financial officers.

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Investing Activities

Significant components of the Company’s investment activities are (i) capital expenditures, (ii) insurance costs related to the former founders’ shares redemption program, (iii) strategic acquisitions and (iv) short-term investment purchases and sales.

Investing activities used $17.7 million of cash during 2004. These activities included capital expenditures of $6.3 million, life insurance premiums of $4.8 million, capitalized software (other assets) investments of $3.3 million and net purchases of short-term investments of $2.9 million. Funding for these activities came primarily from operating cash flows and periodic sales of short-term investments.

At January 1, 2005, the Company’s short-term investment portfolio had a market value of $6.3 million compared to $3.4 million at January 3, 2004, an increase of $2.9 million, or 85.3 percent. The Company’s portfolio consists primarily of tax-free variable rate demand notes and mutual funds. An allowance for unrealized gains and losses related to this portfolio has been established. Changes to the allowance are reported as a component of other comprehensive income. The allowance was $0.5 million at both January 1, 2005 and January 3, 2004.

Capital expenditures in 2004 were $6.3 million compared to $3.4 million in 2003, an increase of $2.9 million or 85.3 percent. These expenditures were primarily for machinery, tooling for new products, information technology equipment, and software. In 2005, capital expenditures are anticipated to be approximately $7.0 million. These expenditures will again focus on global information technology upgrades, machinery, and tooling. The information technology upgrades will support our move toward a common technology platform for all offices which began in 2004. The machinery and tooling upgrades are necessary to support our new product development and manufacturing schedules as well as gain cost efficiencies.

In 2004, the Company invested $4.8 million ($4.3 million in cash premiums and $0.5 million in reinvested earnings) in the life insurance policies originally purchased to support the Founders’ Shares Redemption Program. At January 1, 2005, these policies had a cash surrender value of $25.8 million. The Founders’ Shares Redemption Program was terminated on November 12, 2004, (See Note 8 to the Consolidated Financial Statements and Founders’ Shares Redemption Program, below). The Company is currently considering various alternatives with regards to the future of these policies.

Net investment in other assets, primarily capitalized software, increased $3.3 million in 2004 as compared to 2003. In 2003, the net investment increased $2.9 million over 2002. These expenditures reflect the Company’s increased emphasis on software product development.

Net cash used for investing activities was $16.1 million in 2003 compared to $0.9 million in 2002. The largest usage in 2003 was $9.3 million for company and product line acquisitions, followed by the increase in the founder’s life insurance program of $4.9 million and capital expenditures of $3.4 million. Proceeds from trading activities within the short-term investment portfolio provided funds of $4.5 million in 2003.

Financing Activities

The Company’s principal financing activities are the issuance of common stock in connection with the exercise of stock options and shares purchased in the employee stock purchase plan and the payment of dividends on its common stock outstanding.

In 2004, financing activities have provided cash of $1.4 million versus a use of $1.3 million in cash for the comparable period in 2003.

In 2004, 374,199 shares of common stock were issued in connection with employee stock options and purchase plans which generated $3.2 million of cash. In 2003, 76,020 shares were issued under employee stock options and purchase plans which generated $0.5 million of cash.

The Company paid annual dividends at a rate of $.10 per share in both 2004 and 2003, requiring the use of $1.7 and $1.9 million of cash, respectively. Dividend payments related to shares in the Founders’ Share Redemption Program, after July 1, 2003, and prior to the programs’ termination on November 12, 2004 are classified as interest expense and included as a component of other income and (expense) in accordance with SFAS No. 150. These payments have totaled $0.3 and $0.2 million in 2004 and 2003, respectively. At the termination date dividend payments previously classified as interest expense were paid and thus settled while the repurchase agreements were accounted for as a liability and therefore not reversed to income.

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In September 2000, the Board of Directors authorized a common stock repurchase program of up to one million shares of outstanding stock. The timing of the program and amount of the stock repurchases will be dictated by overall financial and market conditions. There were no shares repurchased in 2004, 2003, or 2002 under this program. During 2001, the Company repurchased 231,364 shares at an average cost of $7.56 per share.

The Company anticipates that its current liquidity, future cash flows, and bank credit line will be sufficient to fund operations, life insurance premiums, capital expenditures, research, development, and financing needs for the foreseeable future. Should additional funding be required, supplemental borrowing arrangements are the most probable alternative for meeting capital resource and liquidity needs. The Company maintains a revolving line of credit of $20 million and a capital expenditure line of credit of $5 million.

Founders’ Shares Redemption Program

During 1998, the Company entered into agreements with its founding shareholders for the future repurchase of 4.5 million shares of the Company’s outstanding stock. The agreements were terminated on November 12, 2004. At that time, 3.4 million shares remained subject to repurchase. Prior to their termination, the agreements required stock repurchases following the later of the death of each founder and his spouse. The price the Company would have paid the founders’ estates for these shares reflected a 10 percent discount from the average closing price for the ninety trading days preceding the later death of the founder and his spouse, although the discounted price would not have been less than $10 per share (a total of $45.4 million) or more than $25 per share (a total of $113.5 million). The cost of the purchase agreements was funded by $160.0 million of death benefits from life insurance policies the Company purchased on the lives of certain of these individuals. Insurance was purchased at the $160.0 million level in order to cover both the maximum aggregate purchase price and anticipated borrowing costs. Life insurance premiums total $4.3 million each year while all the policies remain in effect. In 2004, the Company’s investment results on its insurance portfolio exceeded the underlying policy costs by $0.5 million. This income was classified as a component of general and administrative expenses. In 2003 and 2002, policy costs exceeded investment results by $0.6 and $1.4 million respectively.

The Company purchased 1.12 million shares at $10 per share or $11.2 million under the terms of the agreement in January 2002. This founder was not insured; therefore, as anticipated at the time the agreement was entered into, the Company funded this obligation with cash and short-term investments.

In July 2003, the Company adopted SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. Statement 150 generally requires liability classification for classes of financial instruments that represent, or are indexed to, an obligation to buy back the issuer’s shares. Many of the financial instruments within the scope of Statement 150 were previously classified by the issuer as equity or temporary equity. This Statement required the Company to account for its temporary shareholders’ investment related to the Founders’ Shares Redemption program as a long-term liability for the duration of the agreements. Because the underlying shares in the program were the Company’s common stock, they remained as a component of the calculation of basic and diluted earnings per share. In addition, future changes in the valuation of the liability, as well as dividend payments on the program shares will be classified as interest expense.

At January 3, 2004, the remaining shares subject to the agreements were classified on the balance sheet as a long-term liability. The valuation of $34.9 million was determined by multiplying the applicable shares by $10.19 which represents the average closing price of the Company’s common stock, after applying the 10 percent discount, for the ninety trading days preceding that date.

As previously, noted, on November 12, 2004, the remaining Founders and the Company mutually agreed to terminate the Founders’ Shares Redemption Agreements in their entirety. Upon termination, the Company recorded a credit to interest expense of $9.0 million, which reversed the accumulation of the liability to increase the value of the agreements that has occurred since the adoption of SFAS No. 150 on July 1, 2003. Upon reversal of these charges, the remaining $34.2 million representing the fair value of the redemption agreements at July 1, 2003, was reclassified to shareholder’s investment. Dividend payments previously classified as interest expense were paid and thus settled while the repurchase agreements were accounted for as a liability and therefore not reversed to income. Divided payments on program shares were $0.3 and $0.2 million for 2004 and the third and fourth quarter of 2003, respectively.

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Acquisitions and Divestitures:

During the second quarter of 2004, the Company acquired Moniga Gremmo S.r.l., an industrial and ink formulation software developer located in Milan, Italy for $0.7 million in cash. Under the terms of the agreement, the Company all operating assets, software code, intellectual property and customer relationships. This acquisition will give the Company access to new markets and customers in Western Europe and provide additional software capabilities. The acquired products will be integrated with existing X-Rite products within the next twelve months.

On June 30, 2004, the Company sold the primary assets of its Coherix subsidiary for $0.8 million. Under the terms of the agreement, the purchaser received all operating assets and intellectual property. The purchaser made an initial payment of $0.1 million with the remaining balance secured by a non-interest bearing note due in installments over a six-year period. The Company will record gains on the sale as payments are received on the note. As a result, the Company has recorded a deferred gain on the balance sheet of approximately $0.5 million, representing the discounted value of the note.

In March 2003, the Company acquired the ColoRx ^® spectrophotometer product line and related assets of Thermo Electron Corporation for $0.5 million. The Company has assumed service and support obligations for the current installed base of ColoRx as part of the transaction. In an event related to this transaction, the Company entered into a five-year agreement with Benjamin Moore & Co. to be the preferred provider of color management solutions to Benjamin Moore authorized dealers. Prior to the acquisition, Thermo Electron was the preferred provider of color measurement equipment to Benjamin Moore & Co.

In April 2003, the Company acquired the ccDot meter product line of Centurfax Ltd. for $1.5 million, including all intellectual property and related software for the products. Centurfax Ltd. is a London based company that develops and distributes products serving the pre-press and printing industries. The acquired products consist of quality control instruments that ensure accurate measurement of film, offset litho plates, and digital proofing solutions.

On July 1, 2003, the Company acquired the assets of Monaco Systems Incorporated of Andover, Massachusetts, a leading developer of color management software to the graphic arts and photographic markets valued at $11.0 million. The Company expects that this acquisition will enhance its position and product offerings in the color management software markets. The purchase price included a cash payment of $7.0 million and X-Rite common stock valued at $2.5 million at the date of the acquisition. In addition, the seller is also eligible for contingent payouts of $0.75 million in cash and $0.75 million of X-Rite common stock. These payouts were contingent upon the seller’s continued employment with the Company to certain future dates. Total acquisition related costs of $0.5 million were incurred as a result of this transaction and have been included in the determination of purchase price. These costs were for investment banking, accounting, and legal services. The cash portion of the transaction was funded from the Company’s operating funds and short-term investments. Tangible and intangible assets acquired in the purchase include Monaco’s entire line of color management products, all operating assets, trademarks and trade names, technology and patents, covenants not to compete, customer relationship intangibles and goodwill.

For the year ending January 3, 2004, total sales from these acquisitions were $7.6 million

Other Investments

XR Ventures, LLC (XRV) is a strategic venture capital group formed in 2000 and majority owned by X-Rite. Its mission is to direct and manage the Company’s investments in start up companies in high technology fields. The Company’s partners in the group are Dr. Peter M. Banks and Mr. James A. Knister. Both have had extensive careers as executives in technology companies. In addition to their roles with XR Ventures, both serve on the Board of Directors of X-Rite, Incorporated. The venture group sought out, but is not restricted to companies with technologies that are directly related to current Company technologies, or technologies that the Company is interested in pursuing including biosensors, micro mechanical systems, telecommunication components, and information technologies. At December 28, 2002, XRV held minority positions in eleven companies, with a total net investment of $3.2 million. In 2003, these investments were deemed impaired and charges of $3.7 million, which included additional investments of $0.5 million made in 2003, were recorded. The Company has elected not to fund new investments by XRV, but may invest in current holdings to protect the Company’s position with regards to future distributions by the investee. In the fourth quarter of 2003, the Company amended its agreement with Dr. Banks and Mr. Knister. Under the terms of the amended agreement, X-Rite will remain as the sole managing member and will receive reimbursement for all cash for investments and expenses prior to any distributions to Dr. Banks and Mr. Knister Dr. Banks and Mr. Knister will forego any success fees contemplated in the original agreement and will retain their membership interests. Dr Banks and Mr. Knister have not been compensated for

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their services to XRV. The Board of Directors of the Company evaluated the fairness, on-going risks, and uncertainty involved in partnering with two of its directors. The arrangement and subsequent amendment was negotiated at arms-length with Dr. Banks and Mr. Knister who were represented by their own counsel while the Company was represented by its regular counsel.

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with generally accepted accounting principles in the United States requires management to adopt accounting policies and make significant judgments and estimates to develop amounts reflected and disclosed in the financial statements. In some instances, there may be alternative policies or estimation techniques that could be used. Management maintains a thorough process to review the application of accounting policies and to evaluate the appropriateness of the many estimates that are required to prepare the financial statements. However, even under optimal circumstances, estimates routinely require adjustment based on changing circumstances and the receipt of new or better information.

The policies and estimates discussed below include the financial statement elements that are either the most judgmental or involve the selection or application of alternative accounting policies and are material to the financial statements. Management has discussed the development and selection of these accounting policies with the Audit Committee of the Board of Directors.

Accounts Receivable Allowances

Accounts receivable allowances are based on known customer exposures, historic credit experience, and the specific identification of potentially uncollectible accounts. In addition to known or judgmental components, a policy that consistently applies reserve rates based on the age of outstanding accounts receivable is followed. Actual collections may differ requiring adjustments to the reserves.

Inventory Reserves

Inventories are valued at the lower of cost or market. In assessing the ultimate realization of inventories, we make judgments as to future demand requirements and compare these to current inventory levels. Reserves are established for excess and obsolete inventory, based on material movement, market conditions, and technological advancements.

Self-Insurance Reserves

The Company is self insured up to certain limits for costs associated with benefits paid under employee health care programs. The measurement of these costs requires the consideration of historic loss experience and judgments about the present and expected levels of costs per claim. These costs are accounted for by developing estimates of the undiscounted liability for claims incurred, including those claims incurred but not reported. This method provides estimates of future ultimate claim costs based on claims incurred as of the balance sheet date.

Long-Lived Assets

Evaluations are periodically made of long-lived assets and the Company’s venture capital investments for indicators of impairment when events or circumstances indicate that this risk may be present. Judgments regarding the existence of impairment are based on several factors including but not limited to, market conditions, operational performance, technological advancements and estimated future cash flows. If the carrying value of a long-lived asset is considered impaired, an impairment charge is recorded to adjust the asset to its fair value.

Goodwill

The Company has $7.4 million of goodwill recorded as of January 1, 2005, related to prior acquisitions. Accounting standards require that goodwill must be reviewed for impairment at least annually and as indicators of impairment occur, and the cessation of amortization. The annual evaluation of goodwill impairment requires the use of estimates about the future cash flows of each reporting unit to determine estimated fair values. Changes in forecasted operations and changes in discount rates can materially affect these estimates. However, once an impairment of goodwill has been recorded it cannot be reversed.

Deferred Tax Valuation Allowance

The Company periodically evaluates its deferred tax assets to assess the probability of their being ultimately realized. Upon determination that a deferred tax asset may not be realized a valuation allowance is established for the potential unrealizable amount. This evaluation process requires a review of the underlying transaction to determine that the conditions that led to the creation of the asset still exist and that the related tax benefit will be realized.

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Risk Factors

There are many risk factors that may adversely affect our operating results; risk factors that we deem critical include the following:

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Off Balance Sheet Arrangements and Contractual Obligations

The Company has no significant off balance sheet transactions other than operating leases for equipment, real estate, and vehicles. It also is not the Company’s policy to issue guarantees to third parties. The following table summarizes the Company’s future operating lease obligations by year. (in millions)

Other Matters

In November of 2001, the Company’s Board of Directors adopted a Shareholder Protection Rights Plan (the “Plan”), which became effective in the first quarter of 2002. The Plan is designed to protect shareholders against unsolicited attempts to acquire control of the Company in a manner that does not offer a fair price to all shareholders.

Under the Plan, one purchase right automatically trades with each share of the Company’s common stock. Each Right entitles a shareholder to purchase 1/100 of a share of junior participating preferred stock at a price of $30.00, if any person or group attempts certain hostile takeover tactics toward the Company. Under certain hostile circumstances, each Right may entitle the holder to purchase the Company’s common stock at one-half its market value or to purchase the securities of any acquiring entity at one-half their market value. Rights are subject to redemption by the Company at $.005 per Right and, unless earlier redeemed, will expire in the first quarter 2012. Rights beneficially owned by holders of 15 percent or more of the Company’s common stock, or their transferees and affiliates, automatically become void.

The Company is exposed to a variety of risks including foreign currency exchange fluctuations, and market volatility in its investment and insurance portfolios. In the normal course of business, the Company employs established procedures to evaluate its risks and take corrective actions when necessary to manage these exposures. The Company is not a party to any derivative instruments.

Foreign Exchange

Foreign currency exchange risks arise from transactions denominated in a currency other than the entity’s functional currency and from foreign denominated transactions translated into U.S. dollars. The Company’s largest exposures are to the Euro and British Pound Sterling. As these currencies fluctuate relative to the dollar, it may cause profitability to increase or decrease accordingly.

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The following report, financial statements, and notes are included with this report:

Management’s Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of January 1, 2005 based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of January 1, 2005.

Management’s assessment of the effectiveness of our internal control over financial reporting as of January 1, 2005 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which appears on page 27.

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Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting

The Board of Directors and Shareholders of X-Rite, Incorporated

We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting, that X-Rite, Incorporated and subsidiaries maintained effective internal control over financial reporting as of January 1, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). X-Rite, Incorporated and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that X-Rite, Incorporated and subsidiaries maintained effective internal control over financial reporting as of January 1, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, X-Rite, Incorporated and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of January 1, 2005, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of X-Rite, Incorporated and subsidiaries as of January 1, 2005 and January 3, 2004, and the related consolidated statements of operations, shareholders’ investment, and cash flows for each of the three years in the period ended January 1, 2005 of X-Rite, Incorporated and subsidiaries and our report dated March 9, 2005 expressed an unqualified opinion thereon.

Ernst & Young LLP

Grand Rapids, Michigan

March 9, 2005

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders of X-Rite, Incorporated

We have audited the accompanying consolidated balance sheets of X-Rite, Incorporated, and subsidiaries as of January 1, 2005 and January 3, 2004, and the related consolidated statements of operations, shareholders’ investment, and cash flows for each of the three years in the period ended January 1, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule 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 consolidated financial position of X-Rite, Incorporated and subsidiaries at January 1, 2005 and January 3, 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended January 1, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of X-Rite, Incorporated and subsidiaries’ internal control over financial reporting as of January 1, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2005 expressed an unqualified opinion thereon.

Ernst & Young LLP

Grand Rapids, Michigan

March 9, 2005

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X-RITE, INCORPORATED AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands)

The accompanying notes are an integral part of these statements.

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X-RITE, INCORPORATED AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS – Continued

(in thousands, except share and per share data)

The accompanying notes are an integral part of these statements.

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X-RITE, INCORPORATED AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)