Use of the Report on Business as a Forecasting Tool
Lee Buddress, Ph.D., C.P.M.
Lee Buddress, Ph.D., C.P.M., Portland State University, P.O. Box 751, Portland, OR 97207, 503/725-4769, firstname.lastname@example.org
Alan Raedels, Ph.D., C.P.M.
Alan Raedels, Ph.D., C.P.M., Portland State University, P.O. Box 751, Portland, OR 97207, 503/725-3728, email@example.com
84th Annual International Conference Proceedings - 1999
Abstract. The NAPM Report on Business is widely acknowledged to be among the most accurate indicators of economic performance available. In spite of its broad acceptance, it may not be used to its fullest benefit by the very purchasing professionals who generate it. This paper discusses the use of the ROB as a forecasting tool by purchasing professionals. Other forecasting tools useful to purchasers are discussed, as well.
Introduction. The activities of a company are often largely driven by its forecasts. Sales forecasts drive production levels, hiring and firing, capital investment and purchases, among many other activities. How well each of these matches actual customer demand largely depends on how well marketing understands customers and their needs, and on how well that knowledge is translated into forecasts.
The tools that firms use and the formality of the forecasting process may differ widely. Some firms have formal forecasting activities that include monthly reviews and adjustments as economic conditions change. Others make only annual forecasts without even tracking forecast against actual events. Still others forecast very well in terms of total dollars of revenue, yet fail to accurately predict sales of specific products or product lines.
In a recent article, a firm was described as forecasting well enough that if their activity level was not within five percent of forecast, they considered themselves to be out of control1. They were asked whether they would turn down a large order if it would result in more than five percent growth above forecast. They replied that of course they would accept the order, but they would immediately investigate to determine why they didn't know the customer well enough to see the order coming. In another instance with which the authors are familiar, a firm found that it could build more accurate forecasts of future raw materials and components demand by using historical consumption data rather than relying on marketing forecasts of finished goods sales. Clearly, there is competitive advantage in good forecasting.
This purchasing situation also illustrates the other side of a firm's forecasting responsibility. Many firms invest significant time and effort forecasting sales, but forecasts of raw materials and components availabilities and costs may be just as important. Vast increases in sales are only useful if they can be supported by operations or manufacturing. Without the ability to increase production at the same rate as sales increase, a firm risks late deliveries and irate customers. Forecasts of supply availability should be made just as diligently as those for demand.
NAPM Report on Business. Members of the National Association of Purchasing Management have one of the best forecasting tools available.2 The Report on Business (ROB) has been published by NAPM since 1920 and is acknowledged to be superior to most government data in providing information about activity in the manufacturing sector of the economy. This year, NAPM has enhanced that information by beginning a report on the non-manufacturing sector, as well. Now, NAPM members have available each month in Purchasing Today, a complete look at the nation's economy.
NAPM utilizes change indices throughout the Report on Business. A change index does not measure the level of an activity; rather it records the change in level of activity from month to month. The ROB uses "50" as the zero change point, where data above that number indicate the activity is expanding, while numbers below 50 show an activity in decline.
There are three reasons why the NAPM data is so valuable as a forecasting tool. First is its timeliness. The information is released on the first working day of each month, detailing changes in activity from the previous month. As such, this information is the most timely of the readily available economic indicators.
To be able to generalize from the results of a sample to the population as a whole, the sample must be selected to accurately reflect the population as a whole. NAPM very carefully selects the survey respondent firms to accurately reflect, by SIC code and by geographic area, a cross section of both the manufacturing sector on the one hand, and the service sector on the other. This careful selection process means that the survey results accurately reflect changes across the entire sector.
Leading economic indicators are those that change direction in advance of changes by the economy as a whole. As such, this type of indicator is extremely valuable to forecasters. By definition, a change index such as the NAPM ROB is a leading indicator. Change indices lead the activity indices they mirror by one quarter of a business cycle. In other words, peaks and valleys of the change index will precede peaks and valleys of the activity index by one quarter of a business cycle3. See Figure 1 for an illustration. (Figure 1 is not available in text-only version of this document.)
Forecasting With the Report on Business. Key issues in supply management include availability of raw materials and components, lead times, inventory levels, prices and, and supplier performance. Changes in several of these are directly measured by the NAPM Report on Business. Others can be developed inferentially from the data.
Changes in inventory levels are directly measured, both for the manufacturing and service sectors. The Report released on December 1, 1998 with data for November, 1998, shows the manufacturing inventory index at 44.9, continuing the decline in inventories which spans several years. The non-manufacturing inventory index was 50.0, indicating no change from the previous month, which did show contraction. In addition, the non-manufacturing report contains an indicator of Inventory Sentiment - opinions of the respondents regarding the level of their inventories. The December Sentiment Index was at 63.0, indicating that the majority of respondents thought their inventories were "too high". Declining inventory levels suggest that purchasing forecasting and planning are more important than ever as suppliers no longer hold the large inventories which previously protected us from our bad forecasting.
By observing the charts for production, new orders and backlog, deductions about lead times can be made. For example, what if new orders were increasing, and production were constant, while backlogs decline. One could infer that lead times are likely to be constant to slightly declining. If production is constant while new orders increase and backlogs decline, the rate of production is likely to be greater than the rate of increase in new orders. The November, 1998 data show new orders (45.5), production (48.6) and backlog (40.5) all well below the zero change point of 50. The conclusion is that lead times should be decreasing at this time.
Of all the measures of change included in the ROB, one is an inverse indicator. Supplier Deliveries decline as the economy improves and suppliers have an increasingly difficult time delivering promptly. Conversely, as the economy slows, supplier deliveries improve. For this reason, NAPM inverts this indicator so that all of the indicators track in the same direction. Supplier Delivery numbers above the zero change point of 50, for this indicator alone, indicate that supplier deliveries are worse, while data points below 50 indicate improvement.
Other data from November, 1998 for the manufacturing sector show the following:
|Production||48.6||Contracting from growth in October|
|New Orders||45.5||Contracting at a more rapid pace than in October|
|Backlog||40.5||Contracting at a more rapid pace than in October|
|Supplier Deliveries||50.2||Essentially unchanged|
|Inventories||44.9||Contracting at a more rapid pace than in October|
|Employment||44.9||Contracting at a more rapid pace than in October|
|Prices||35.0||Contracting at a more rapid pace than in October|
The Purchasing Managers' Index. Five of these indicators (production, new orders, supplier deliveries, inventories and employment) are included in the composite indicator called the Purchasing Managers' Index (PMI). This compilation enables forecasters to have a single indicator of overall performance. While this may be valuable, it is important to examine each of the individual indicators to determine the underlying strengths and weaknesses in the sector. The PMI is reported widely immediately upon release each month by the business media including The Wall Street Journal, Business Week, and most other business press. The information is also available from the NAPM Web site at www.napm.org. The November PMI was 46.8, indicating a contraction of the manufacturing sector. Comparing this to the October PMI of 48.3, suggests that the decline was more rapid in November than October. Overall then, it is clear that the manufacturing sector of the economy is contracting at a more rapid rate than it was in the previous months.
Another way in which the Report on Business is useful to purchasers is a forecasting tool for commodity prices.4 A high degree of correlation has been shown between certain types of commodity prices and the NAPM Report on Business. Global market structure is a key determinant of applicability. Commodities that are cartel or oligopolistically controlled do not respond in concert with the Price Index. Competitive commodities, however often are reflective of the turning points exhibited by the NAPM data. For example, aluminum, zinc, tin, lead and copper all show at least some significant correlation, while other, less globally competitive commodities did not.
Other Indicators. Capacity utilization rates for the nation's factories are reported monthly by the Department of Commerce. There are two definitions of capacity that are important. The first is design capacity - the output that a machine might produce when operating at its highest rate, uninterrupted. Realistically, this level of production may be achieved in spurts, but is unlikely to be sustained for long periods. The second definition is demonstrated capacity - that level of operation, which could be sustained, long term.
History suggests that the long term, sustainable demonstrated capacity of the nation's factories is in the vicinity of 91% of design capacity. With this in mind, inferences might be made as follows. If the utilization rate were at 78%, purchasers could expect that product availability would be good and there would be little, if any, upward pressures on price. Supplier performance should be good with lead times short. Inventories should be sufficient to plentiful, because sufficient capacity exists to respond to purchasers' requirements.
When the economy grows rapidly and factory utilization rates increase to 86 or 87%, then a very different set of inferences are derived. Product availability now becomes tight, with significant upward price pressures. Supplier performance declines as lead times stretch out. Inventory levels decrease and purchasing forecasting and planning become more critical. Even service business need materials and supplies to operate. Availability, lead times and pricing are as important for services as for manufacturing. This indicator is of significant assistance in forecasting adequacy of supply. Presently, capacity utilization is 2.3% less than last year.
Other associations also produce economic survey data from surveys of their membership. APICS, for example, publishes its Business Outlook Index. This index also reports activity in the manufacturing sector, but in a somewhat different fashion. While not as timely as the NAPM Report, it nonetheless is both useful and interesting. This Index includes both a Current Component and a Future Component. Manufacturing Shipments, Manufacturing Employment, Manufacturing Production, Unfilled Orders and Inventories are included in the Current Component. Durable Goods New Orders, Production Planning and Inventory/Sales Ratio comprise the Future Component. The Business Outlook Index is published monthly in APICS - The Performance Advantage, and is also available from www.apics.org. Government statistics of value include the Producer Price Indices, which is a composite of three price indicators: crude materials for further processing, intermediate materials, supplies, and finished goods. The 1998 data for each of these, are: crude materials, -12.3%; intermediate materials, -1.9% and finished goods, -1.1%. Clearly, industrial prices show deflationary trends. Similarly, the Consumer Price Index shows a very low inflation rate of +1.6%.
Finally, actual firm-specific data such as sales, supply prices, new orders and others can be evaluated in comparison to the indicators discussed above. It is likely that one or more of these will show correlation to firm data and prove valuable as a forecasting tool. For example, over the past decade, if the overall economy expanded, how did firm sales change? As the economy expanded, what happened to key raw material availability and price? Can a model be constructed that will estimate firm changes in response to economic change? The ability to construct "what if" scenarios to develop supply and manufacturing responses is extremely valuable for strategic planners. This is the sort of strategic contribution that is expected of today's purchasing and supply professionals.
Conclusions. Purchasers today have several readily available indicators of economic performance. While the NAPM Report on Business has been shown to be the most accurate, each of the others discussed here is useful. Each casts a slightly different light on the performance of the economy. Each is readily accessible. Together, they allow forecasters, in a relatively short time, to gain a sense of economic performance upon which to base projections of future activity. Accurate estimates of demand and indicators of supply are crucial in today's global competition.
- Finegan, Jay. " Everything According to Plan." Inc. , March 1995, p. 78.
- Hoagland, John H. and Taylor, Barbara. "Purchasing Business Surveys: Uses and Improvements." Proceedings of the 72nd Annual International Purchasing Conference, 1987, p. 167. Also see Klein and Moore. "NAPM Business Survey Data: Their Value as Leading Indicators." Journal of Purchasing and Materials Management, Winter, 1988, pp. 32-40.
- Klein, Philip and Moore, Geoffrey. "NAPM Business Survey Data: Their Value as Leading Indicators." Journal of Purchasing and Materials Management, Winter, 1988, pp, 32 - 40.
- Buddress, Leland and Raedels, Alan. "Forecasting Commodity Price Movements Using the NAPM Report on Business." Proceedings of the Western Decision Sciences Institute, March, 1991.