This is dialogue between Mr Curious(C) and Mr Omniscient (O) on release of PMI which is at its two year low of 50.6
C: Today Purchasing Mangers’ Index for manufacturing process is released. It is 50.6. Some News is claiming that it is worrisome situation. But alongwith that it also been said that PMI of greater than 50.6 means expansion. I am curious to know, whether is it good or bad.
O: To come to any conclusion we need to understand what is PMI. However, by names itself you should able to guess what is it. Can you guess?
C: Hmmmm! I think is some sort of Index which is prepared on basis of purchases of manufactured product.
O: You are partial right. See the name carefully; it is Purchasing Managers’ Index not the Purchasing Index. Do you know in every company there are mangers that are responsible for purchasing of input material for their company?
C: Yes. I know that. For instance, in Car Manufacturing Plant, there would be a manger that will be responsible for purchasing of raw material for car manufacturing.
O: Good. Now put yourself in shoe of car manufactures’ Purchasing Manger. And you have to decide how much more raw material you need to buy. On what factors that decision will depends upon?
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C: I think, it will depend upon how much more cars need to be manufactured.
O: Yes!! If there are more order for new cars, that means more purchases of input material. But let’s say last month, you have already bought more than your requirement of raw material and it is laying there in your plant unutilized, then will you buy more raw material.
C: Off-course not, I will consume that raw material first.
O: This unutilized or partial utilized or unsold finished product is called inventory. So your decision to purchase more input material will depend upon inventories level and new orders. In same way there are various economic variable of manufacturing plant which represents the health of manufacturing industry. Some of these parameters are New orders, New export orders, Output prices, Input prices, Employment etc. Now tell me, what is the best way to know about the health of manufacturing industry?
C: Simple!! Ask the views of mangers about above parameters.
O: Absolutely right. In fact, a questionnaire asking about the opinion regarding above type of parameters is send to a survey panel of senior purchasing executives (or similar) at around 400 companies.
C: What exactly, do they ask in the survey?
O: They ask questions about business conditions and any changes on these parameters, whether it is/will be improving, no changes, or deteriorating.
C: What they do with their responses.
O: On basis of their responses PMI is calculated by using following formula
PMI = (PIm * 1) + (PNc * 0.5) + (PDe * 0)
PIm = percentage of answers reporting an improvement
PNc = percentage of answers reporting no change
PDe = percentage of answers reporting a deterioration
On basis of above formula can you tell me what value PMI can take?
C: I don’t know
O: Think over it. See carefully, what can be maximum value of PIm?
C: As PIm is percentage of answers reporting an improvement. And if all the people report the improvement than its value would be 100% and in that case PNc and PDe would be zero
O: Absolutely right!! So maximum value of PMI would be ….
C: 100, if all reports improvement. And zero if all report deterioration
O: Good!!. So PMI can varies from 0 – 100. So now tell me if its value is 50, what does that mean?
C: Can’t tell.
O: Let’s make it simple. IF there are 1,00 responses, then in which case PMI will be 50.
C: When all 100 reported no change. (From formula : PMI = PIm * 1 + PNc * 0.5 + PDe * 0)
O: What about the case where 10 responded improvement and equal number responded deterioration and rest of 80 responded no change.
C: In that case also PMI value will be 50. That means when equal number of people reported improvement and deterioration and rest reported no change, then PMI will be 50. That means over perception is of No change.
O: Right. So, overall we can say that less than 50 PMI represents the contraction, greater than 50 PMI represents expansion and a reading at 50 indicates no change. Tell me at what value of PMI you will consider the more expansion. At level of 60 or 70.
C: Off-course at level of 70. That mean more number of purchasing managers are expecting the expansion compare to number of mangers who are expecting the contraction.
O: Good! That means further away from 50 the greater the level of change. PMI of 30 represents more severe contraction compare to PMI of 40.
C: So when we say that PMI for manufacturing is 50.6 that mean expansion in economy, which is good. Right?
O: Yes, it means expansion. But it is not good if compared to previous month’s PMI. It is slowed down from the level of 51.4 in month of September to 50.6. It is at its two years low level. In fact, quantities of purchases is contracting for the third month in a row and consequently input costs fell for the first time in over four years during October.
C: Okie!!! But you told me value greater that 50 is expansion
O: Remember PMI is not only about the purchases raw material, but lots of other parameters. You can find the detail list at ihsmarkit. Further here contraction means decreasing PMI. It was 52.5 in Jul 2019, then fallen to 51.4 in Aug and Sept and now 50.6 in month of October.
C: Okie!! Is it calculated for manufacturing only?
O: No!! However PMI for manufacturing is most widely used, but PMI for Service and construction is also calculated. In fact PMI for Whole economy is also calculated.
C: Who does all these calculation? Is some government agency does that?
O: No!! PMI data is complied and released by IHS Markit. They do this exercise for many countries. For USA this exercise is done by the Institute for Supply Management (ISM). In every second half of month this survey is done and date is release at the start of next month. For example to get the PMI for month of October the IHS Markit started survey in second half of October month and released PMI data on 1st November.
C: Okie… I am little curious that PMI data reflects more about the perspective of Purchasing Manger. For example, he will report improvement in purchase if he expects more new orders. Does not that mean PMI will tell in advance about the actual output? What I want to say that if PMI is reported lower then it means that growth in Economy will be slow.
O: Excellent!!! You hit the Bull’s eye. There are very few indicators which tell you about the future or give hint about the futures. These type of indicators are called leading indicators and various managerial decision are taken on basis of these indexes. But however, it is just a survey which reflects the perception.
C: And perception can go wrong sometime as we have discussed in case of stock market.
O: Yup!!! But here chance of being wrong is lesser as there is factor of herd following is missing.
C: But you never know……..
O: I want to leave you with a thinking point. Discuss with your friends. Think that, why PMI for manufacturing is so important. In News, you will see mostly PMI for manufacturing not so much about PMI for services or PMI for Whole economy. Why is it so? We will discuss it some other time.