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The actual score for each category is then calculated by taking the percentage of respondents who say activity is increasing and adding it to half the percent of those who say the area has stayed the same. What Do You Say? Click Here to Send Us Your Comments Click Here to See Reader Feedback

The Purchasing Managers Index (PMI) is one of the most widely reported measures of the health of the economy, not only in the United States but throughout the world. The first such near real-time economic indicators were launched in 1931 by the predecessor to today’s Institute of Supply Management (ISM), and the current PMI was developed by ISM in the 1980s. There are now PMIs is several dozen other countries, including China, whose monthly PMI is now watched almost as closely as that in the US.

But despite the prominence of the PMI, how well do business leaders and supply chain managers really understand how the data is calculated, and what it means?

To clarify some of those issues, SCDigest recently spoke with Norbert Ore to gain a better understanding of the indices. Ore is a former supply management executive at Georgia-Pacific and other companies and current chair of the ISM report on business.

The monthly report in the US is based on the responses to a standard questionnaire sent to reporting members at some 350 companies. The population by manufacturing sector of those responding companies is closely proportionate to their size in the manufacturing economy.

The respondents are generally procurement/supply management executives at their given companies.

“We believe supply managers are often best positioned to have the pulse of the companies overall business activities,” Ore told us.

Of course, no one person is likely to initially have at their fingertips comprehensive data about procurement, inventories, orders, etc., so new member companies usually have to have some supporting work done to collect the data needed for the report.

“I tell new members they will really get to understand what is happening in the business as the result of this process,” Ore said.

While to some, 350 may seem like a relatively small number, Ore said ISM is not looking to expand the number of respondents, as he and others their do not believe an increase would actually improve or change the results. In fact, he said when China was looking to start its version of the PMI, developers there initially thought hey would recruit thousands of respondents, but wound up with a similar number to the US survey population in the end.

Respondents are asked to provide input on 10 different company-specific economic indicators, which together create the overall PMI indices (see below). Ore said each month some two-thirds of the 350 members submit responses. He said ISM has looked before the first 100 respondents, and found that those results usually closely mirror the full results.

(Supply Chain Trends and Issues Article - Continued Below)

Diffusion Index Approach

The primary and most widely reported index is the overall PMI score. That metric, in turn, consists of an average of the seasonally adjusted indexes in five core areas: 

• Production (20%)
• New Orders (20%)
• Employment (20%)
• Supplier Deliveries (20%)
• Inventories (20%)

The weighting used to be different across the categories, but in 2008 the PMI was changed to give equal weight to these five categories to improve the correlation between the PMI and US Gross Domestic Product (GDP).

PMI survey respondents are asked to give very simple answers for each of these five categories plus several others that aren’t included in the formal PMI calculation, such as order backlogs and imports, but which are reported in the full The Manufacturing ISM Report On Business. The questions in summary are as follows: In your company, for this month, was the level of activity/volume in each category higher, lower, or the same as the prior month?

So, answers for April, 2010, are relative to March, 2010. ISM then tweaks the overall responses a bit to reflect known seasonal patterns (e.g., orders may naturally rise in September versus August, so that pattern is normalized in the final numbers to represent true directional change).

This approach is what is called a “diffusion index,” a statistical technique used to represent patterns of change.

The actual score for each category is then calculated by taking the percentage of respondents who say activity is increasing and adding it to half the percent of those who say the area has stayed the same.

So, for example, if 40% said order volumes increased, 32% said they stayed the same, and 28% said they declined, the index for orders would be 40 plus 16 (one-half of 32) for a total of 56.

The ISM Data is Shown to Closely Track Ultimate Economic

Data Reported Several Months Later

This then results in the well-known scenario where scores above 50 are generally said to represent expansion, and under 50 contraction in the overall economy (for the full PMI) and each specific sub-category category. The distance from 50 generally indicates relative strength or weakness and rate of change from the previous month.

So, if the PMI goes from 56 to 52 in a given month, it means the economy is still expanding (index over 50) but at a slowing rate (decline of 4 points over the previous month). A change from 53 to 48 means the economy (or that area) has gone from expansion to contraction.

Well, almost.

The inventory category is a bit different, Ore says, than most of the others. Data has shown that any score above 42.6 is actually likely to represent growth in overall US inventories as reported several months later by the US Commerce Dept., based on the Commerce Dept.’s own analysis.

Why? Well, in part it may be the natural tendency for supply managers to think they have well managed inventories for a given period, and so the responses have a bit of a natural bias downwards.

“You see that in normal times, the inventory scores tend to hover in the 44-47 range, which I think represent steady state levels,” Ore told us.

“The PMI and the indexes are meant to provide a very current snapshot of activity and the direction of the economy,” Ore said, “History has shown that it does a very good job of that,” noting that ISM has frequently gone back to compare ISM data to government statistics, which take longer to develop and report (see graphic above).

“So, not only has have the indexes proven to be highly accurate over time, the speed of the reporting gives managers valuable insight into how the environment is changing,” Ore said. 

Did this help your understanding of the ISM PMI and other indexes? Do you look at these numbers each month, and find them useful? Any changes you would like to see? Let us know your thoughts at the Feedback button below.

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