The Value of the ROB
FOR RELEASE: April 1, 1999
Note: Graphics not available for all articles
As purchasing and supply professionals become more sophisticated with their approach to supply chains, it becomes imperative that they understand the value of economic data, and particularly of the tools provided by ISM's Manufacturing Business Survey Committee, the group in charge of producing the monthly report. The Manufacturing Report On Business® is in its 68th year and continues to provide an important measure by which to gauge the U.S. economy. It's the oldest of the two reports produced by the ISM Business Survey Committees; the Non-Manufacturing ISM Report On Business®, developed in 1998, is the most recent. For over six decades, the Manufacturing Report On Business® has served ISM members, government, economists, and the financial community as the source of several leading economic indicators. Today, many different organizations are using the Manufacturing Report On Business® as a key source in assessing the U.S. and global economies.
On the first business day of the month, the Manufacturing Report On Business® is released to the world. Shortly after the release at 10:00 a.m. Eastern Time, there is a press conference with the major wire services. The morning continues with several live and taped radio interviews, and is followed with in-depth interviews by the print media including USA Today, The Wall Street Journal, and Investors' Business Daily. Given the advent of the many business Web sites on the Internet, the monthly release is reviewed and evaluated in New York, Hong Kong, Tokyo, Sydney, London, and Frankfurt at virtually the same time. So what exactly is in this report that is sought by the media and economists each month?
The Nuts and Bolts
The concept for the Manufacturing Report On Business® survey is quite simple. Each month, over 350 ISM members from the manufacturing sector who make up the ISM Manufacturing Business Survey Committee (both the members and their organizations remain anonymous) are asked to assess their performance based on a comparison of the current month to the previous month. Through the use of non-quantitative questions, they are asked if the level of activity is "better," "same," or "worse" than the preceding month. The resulting Manufacturing ISM Report On Business® indexes measure the rate and direction of change, if any, for each surveyed activity.
This questionnaire is sent to committee members each month requesting information on various areas of activity within their organizations. Members respond to questions about
- Level of Production
- New Orders (from customers)
- Backlog of Orders (growing or declining)
- Supplier Deliveries (slower or faster)
- New Export Orders
To achieve a valid, weighted sample, members are selected from the 20 manufacturing Standard Industry Classifications (SIC) categories developed by the U.S. Department of Commerce based on their contribution to Gross Domestic Product (GDP). For example, transportation (SIC class 37) — which includes auto and airplane production — has a higher weight, and, therefore, more members on the committee, than textiles (SIC Class 22).
What It Tells Us
The index that attracts the most attention is the Purchasing Managers' Index (PMI). In an almost mystical fashion, Wall Street attempts to predict the PMI for the upcoming month — it is considered that important by the financial community — though their track record is less than stellar. This index was created by Theodore Torda, an economist at the U.S. Department of Commerce and introduced in February 1982. The PMI provides a signal of the peaks and valleys in the manufacturing sector before they appear in government economic data. In recent years, the PMI has tended to lead manufacturers' profits. It's a composite of five of the indexes, seasonally adjusted, with the following weights applied:
When we look back at 1998, the Manufacturing Report On Business® provided an accurate picture of the unique events that shaped the global economy: the impact of the November 1997 Asian financial crisis surfaced in ISM's New Export Orders which fell under 50 percent in January 1998 for only the second time since the Index was first charted in 1988, and proceeded to stay under 50 percent for all 12 months of the year. See the box above for the New Export Orders data. The PMI continued to grow, but at slower rates during the first half of the year, following an extremely strong fourth quarter in 1997. At mid-year the manufacturing economy began contracting, after a 22-month growth period, and then failed to grow during the balance of the year.
During 1998, many goods producing industries suffered through declining volumes and cost pressures. Oil companies, farmers, industrial equipment producers, exporters, and even importers won't remember the year with fondness. At the other end of the spectrum, consumer spending drove expansion in computers, cellular phones, vehicles, and travel.
How Purchasers Use the Data
The information released each month in the Manufacturing Report On Business® is only of value if professionals can apply the knowledge to their activities. Here are some ways that purchasers can use the data:
- Acquire an understanding of the capability of each of the indexes. The PMI, New Orders, and Supplier Deliveries Indexes are leading indicators (typically by one or more months) and predictors of future growth or contraction. The Production Index is a coincidental indicator and historically correlates with the Federal Reserve Board's Index of Industrial Production and is a good indicator of current production. The Inventories, Employment, and Price indexes are considered lagging indicators and change as a result of variations in New Orders and Production.
- Trends can be plotted from the Prices Index to aid interpretation of the direction and rate of change. The Prices Index is considered by many to be a good indication of future inflation — a great concern earlier in this decade. Expectations are that it will also aid in analyzing deflation, should this become an issue.
- Each release of the Manufacturing Report On Business® includes a list of commodities that are up or down in price. Close scrutiny of this list will provide early indications of actual price changes and any trends of continuing price movement.
- Check the Short Supply List. In recent months, members have reported few items in short supply, an indication that supply has been leading the demand for most products. Historically, this list has been very useful in identifying potential supply bottlenecks.
- The Buying Policy can be used to measure changes in capital investment, just-in-time deliveries, maintenance, repair, and operating purchases. As an example, members are queried about their Buying Policy with regard to capital. They provide their current commitment based on average number of days. The recent cycle of capital expenditures reached its peak in February 1996 when the index hit 153 days; for the 12 months of 1998, the index averaged 122.5 days.
- The Manufacturing Report On Business® is used to forecast expansion or contraction in certain industries. Studies have correlated the PMI to growth in Gross Domestic Product (GDP). Using the coefficient of percent change in GDP, it is possible to predict expansion or contraction in any of the 20 manufacturing SIC categories. This allows purchasing and supply professionals to predict their own industry or that of their major suppliers. (For more information on expansion and contraction in certain industries, see "Make the ISM Report On Business® Work for You," in NAPM Insights, October 1994.)
- The Manufacturing Report On Business® is used in numerous organizations as a leading indicator of other economic indexes. This is a more sophisticated use of the report and requires a monthly revision of the analysis. The ISM Business Survey Committee relies on assistance from the U.S. Department of Commerce to develop correlation to other indexes as validation of the monthly data. The ISM Business Survey Committee also assists these power users with information and explanations, but the development and interpretation is left to the user.
What is a Diffusion Index?
The percent response to the "Better," "Same," or "Worse" question is difficult to compare to prior periods. Therefore, we "diffuse" the percentages for this purpose. A diffusion index takes those indicating "Better" and half of those indicating "Same" and adds the percentages. This effectively measures the bias toward a positive (above 50 percent) or negative index. For example, if the response is 20 percent "Better," 70 percent "Same," and 10 percent "Worse," then the Diffusion Index would be 55 percent (20% + 0.50 x 70%). A reading of 50 percent indicates "no change" from the previous month.
The data for each question is converted to a diffusion index and then seasonally adjusted. (Backlog of Orders is not seasonally adjusted.) The seasonal adjustment factors are provided to the ISM Business Survey Committee by the U.S. Department of Commerce. This allows for the effects of repetitive intra-year variations resulting primarily from differences in weather conditions, various institutional arrangements, and non-moveable holidays. Though typically minor, seasonal adjustments add to the credibility of the Manufacturing Report On Business®.
In recent years, the availability of user-friendly software for the desktop computer has facilitated the presentation of data in graphic form. Diffusion indexes are particularly telling in this form as they take on the properties of leading indicators. The distance away from 50 percent — whether rising or falling — indicates the strength of the growth or decline in an index.
Purchasing and supply managers are far more aware than most of business cycles. We tend to think in terms of "buyer's markets" versus "seller's markets." Identifiable business cycles date back to the middle of the 19th century. To date, there have been 31 complete business cycles and the present one is in its 94th month of expansion as of February 1999 — far exceeding the average of 4.5 years for all business cycles. The upside of a cycle is usually three years and the downside averages 18 months. It is noteworthy that the last two business cycles have now exceeded eight years in duration. Purchasers have played a large role in these successes as they have developed new ways to minimize inventory, such as just-in-time or supplier-managed models. Business cycles have a definite impact on sourcing strategies, and purchasers sensitive to upward and downward trends will be more effective in managing their supply chain costs.
Business cycles are subject to dramatic variability. Both the length of the expansions and contractions and the intensity of the highs and lows will probably always be different. Recent U.S. business cycles have been longer than average, and world events have played major roles (1973 oil embargo, 1991 Mexican financial crisis, 1997 Asian economic crisis). A paradox is that the U.S. economy has been extremely well managed (high productivity, low government deficits, low interest rates) during this recent expansion, but has been slowed by global events. This is proof that purchasing and supply professionals must think globally even if they are not involved in global sourcing.
Follow the Trends
Even seasoned economists fall into the trap of looking at one month's data and developing a forecast for the future. Purchasing and supply managers need to constantly remind themselves of two basic tenets:
- React to trends, not the monthly data. Don't assume that a change in direction in an index is the beginning of a change in direction for the manufacturing sector. Cycles tend to rise and fall in sawtooth movements. Computing a quarterly moving average will smooth the normal oscillations of the market.
- In every economic scenario, there is a winner and a loser. Even in a robust economy there are industries struggling with growth due to over capacity, loss of markets, or new competition. Just as in the stock market, where every transaction involves a seller — who thinks the stock price will go down — and a buyer — who thinks the stock price will go up — there is always someone, somewhere benefiting from the business cycle. In another example, falling oil prices are devastating to producing countries and to certain areas of the United States, however, they have a very positive impact on the U.S. trade deficit.
Data and Words Can Be Deceiving
In reviewing economic reports, and particularly in comparing the ISM reports to the government reports, it's imperative to verify that you are looking at comparable periods and that you understand the use of terms like "growth" and "decline." When the Manufacturing ISM Report On Business® is released, it features data from the month just completed and compared to the prior month. So, on the first business day of April, the Manufacturing Report On Business® releases data on March comparing it to February. Most other economic reports released during the month of April will be announcing February data. Because the indexes measure rates of change, the terminology can sometimes be confusing. A couple of examples might be beneficial.
Over the years, the number of questions has been expanded to include new areas of interest. This is the case with New Export Orders and Imports which were added in the late 1980s. In the late 1980s, questions were added about New Export Orders and Imports. (Both of these indexes have played a significant role in interpretation of economic data during the past year due to the Asian economic crisis and its impact on the U.S. economy.) A current "trial" question is Customer Inventories which attempts to measure supply chain inventory change. It generally takes three to four years of data gathering to determine if a question has sufficient validity for inclusion. So, the final determination on this question may still be some months away, however, it's an interesting concept to look beyond the respondent's organization for an indication of future activity. The future will certainly yield new areas of measurement and those will be intensely debated and evaluated before they make it into the monthly report.
While predicting the actual performance of the manufacturing sector is always a challenge, one thing is certain: those purchasing and supply professionals who continue to analyze that data and use it as a forecast and economic tool will have the advantage.
By Norbert J. Ore, C.P.M., ISM Manufacturing Business Survey Committee chair and director of corporate purchasing at Chesapeake Corporation in Richmond, Virginia.
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The Whole Story
Each month's issue of Purchasing Today® magazine brings readers a synopsis of the Manufacturing and Non-Manufacturing Report On Business®. To view both reports in their entirety, visit the ISM Web site. Shortly after 10 a.m. Eastern Standard Time, the reports are posted: the Manufacturing on the first business day of each month and the Non-manufacturing on the third business day of each month.
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How We Use the Report
Several organizations anxiously await the release of the ISM Report On Business® each month, and then use that information to propel critical business activities. Steve Daniels, global director, procurement and materials, Dresser Equipment Group of Halliburton and Co. in Houston, Texas, shares his processes for using the report:
The data indicated in the monthly ISM Report On Business® is an integral part of our own forecasting efforts, project planning, and ongoing communication with both suppliers and customers. Data points are also quite useful in comparing actual versus target pricing levels and in establishing acceptable ranges and/or controls in contracts.
Regarding forecasting and project planning, a working knowledge of the market and its tendencies is a key to successful project management. We record the monthly ISM Report On Business® indices on a spreadsheet, convert the indices to charts, and distribute this information to our Procurement and Materials Management team on a worldwide basis. This data is often used in projecting and validating escalations and leadtimes during long-term projects.
Regarding communication, the monthly indices and charts are included as a segment in one of our management reports that indicates currency exchange rates, escalations, leadtimes, and production cycle time applicable to major equipment items. Sharing this information with suppliers and customers provides an opportunity to work together to achieve more effective cost management in our supply chain network.
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PMI and the Dow Jones Index: What's the Connection?
Purchasing and supply professionals have long been aware of the benefits of tracking the ISM Report On Business®, and specifically the Purchasing Managers' Index (PMI). In a recent study, "Purchasing Managers' Index Predicts Stock Market Movement," researchers attempt to show the correlation between the main index of the ISM Report On Business® and the Dow Jones Index. Susan Long, graduate research assistant, and Ernest Goss, Ph.D., professor of economics, both at Creighton University in Omaha, Nebraska, say that under different degrees of inflationary fears, the PMI correctly predicts changes in the Dow Jones Index approximately 81 percent of the time. During periods of significant inflationary fears, the relationship between the PMI and the S&P is even stronger, predicting changes 80 to 100 percent of the time. The following table, from their report, shows the relationship between PMI and stock market indices.
|January 1993 to October 1994:||November 1994 to February 1996:||March 1996 to April 1997:||May 1997 to August 1997:|
|period of no significant inflation fears||period of significant inflation fears||period of no significant inflation fears||period of significant inflation fears|
|PMI & Index||81.8%||72.7%||19.0%||19.0%||80.0%||66.7%||0%||0%|
|PMI & Index||18.2%||27.3%||81.0%||81.0%||20.0%||33.3%||100%||100%|
Source: Creighton University
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Non-Manufacturing Report On Business®
In June of 1998, there was a monumental addition to the ISM Report On Business®. For the first time, the report included data on non-manufacturing industries. Released on the third business day of each month, this report shows data based on surveys of more than 370 purchasing and supply professionals from the non-manufacturing industry. There are 17 non-manufacturing categories surveyed, and each month the report gives data on Business Activity, New Orders, Backlog of Orders, New Export Orders, Inventory Change, Inventory Sentiment, Imports, Prices, Employment, and Supplier Deliveries.
How is this information beneficial for purchasing and supply professionals? First, upon its release, it gives individuals and organizations a sense of what is happening in the non-manufacturing economy. Non-manufacturing industries make up about 80 percent of the gross domestic product and all industries are affected by non-manufacturing activities. Even if your organization is manufacturing-based, some components of your supply chain are non-manufacturing and you can determine how their business level is changing. As in the manufacturing report, this report also includes information about commodity prices changes and shortages.
The lead index of the report is the ISM Business Activity Index, which is comparable to the Production Index in the manufacturing report. Although the non-manufacturing report doesn't currently have a number comparable to the manufacturing report's Purchasing Managers' Index (PMI), it is something that may come in the future. The non-manufacturing report only has about two years of historical data, and to develop a PMI-like number will require several additional years.
That this type of report was developed is no surprise, considering the enormous activity in the non-manufacturing field, both in terms of the gross domestic product and purchasing activity. About half of ISM members are from the non-manufacturing environment — one more indication that this sector is vital and worthy of such a report.
By Ralph G. Kauffman, Ph.D., C.P.M., chair of the ISM Non-Manufacturing Business Survey Committee and coordinator of the purchasing and supply management program at University of Houston-Downtown, in Houston, Texas.
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Each month, the ISM Report On Business® measures rates of change. The following examples of terminology used in the report can be useful in analyzing the data.
|Index Moves||Direction||Rate of Change||Net Effect|
|53% to 56%||Up, Growing||Rate of growth is faster||Better than prior month,
|56% to 53%||Down, Growing||Rate of growth is slower||Better than prior month,
|53% to 47%||Down, Contracting||Moved from growth to||Worse than prior month,
index failing to grow
|47% to 43%||Down, Contracting||Rate of contraction is faster||Worse than prior month,
index failing to grow