Purchasing Managers' Index (PMI) Definition and How It Works

What Is the Purchasing Managers' Index (PMI)?

The Purchasing Managers' Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors. It consists of a diffusion index that summarizes whether market conditions are expanding, staying the same, or contracting as viewed by purchasing managers. The purpose of the PMI is to provide information about current and future business conditions to company decision-makers, analysts, and investors.

Formula and Calculation of the Purchasing Managers' Index (PMI)

The PMI is calculated as: 

PMI = (P1 * 1) + (P2 * 0.5) + (P3 * 0)

Where:

• P1 = percentage of answers reporting an improvement  
• P2 = percentage of answers reporting no change 
• P3 = percentage of answers reporting a deterioration 

Other companies also produce PMI numbers, including IHS Markit Group, which puts out the PMI for various countries outside the U.S.  

How the PMI Works

The PMI is a key economic tool and is among the most reliable leading indicators of the U.S. economy. The index is reported by manufacturing and services. There is also a hospital PMI that is released on a monthly basis. The index sheds insight into the business environment and also helps companies get a grasp on where the economy is headed.

It is a survey-based indicator that is compiled and released each month by the Institute for Supply Management (ISM). The survey is sent to senior executives at more than 400 companies in 19 primary industries, which are weighted by their contribution to U.S. gross domestic product (GDP).

The surveys include questions about business conditions and any changes, whether they are improving or deteriorating, or have no changes. The PMI is based on five major survey areas—each of which is weighted equally:

• New orders
• Inventory levels
• Production
• Supplier deliveries
• Employment
  

The headline PMI is a number from 0 to 100. A PMI above 50 represents an expansion when compared with the previous month. A PMI reading under 50 represents a contraction while a reading at 50 indicates no change. The further away from 50, the greater the level of change. 

Using the PMI

The PMI and relevant data produced from the monthly surveys by the ISM are critical decision-making tools for a variety of areas. including management, suppliers, and investors.

Corporate Managers

Management can use the monthly PMI results to make key decisions about their own businesses. For instance, an automobile manufacturer makes production decisions based on the new orders it expects from customers in future months.

Those new orders drive the purchasing decisions of its leadership about dozens of component parts and raw materials, such as steel and plastic. Existing inventory balances also drive the amount of production the manufacturer needs to complete to fill new orders and to keep some inventory on hand at the end of the month.

Suppliers

Suppliers also make decisions based on the PMI. A parts supplier for a manufacturer follows the PMI to estimate the amount of future demand for its products. The supplier also wants to know how much inventory its customers have on hand, which also affects the amount of production its clients must generate.

PMI information about supply and demand affects the prices that suppliers can charge. So if the manufacturer's new orders are growing, it may raise customer prices and accept price increases from its suppliers. On the other hand, when new orders decline, the manufacturer may have to lower its prices and demand a lower cost for the parts it purchases.

A company can use the PMI to help plan its annual budget, manage staffing levels, and forecast cash flow.

Investors

Investors can also use the PMI to their advantage because it is a leading indicator of economic conditions. The direction of the trend in the PMI tends to precede changes in the trend in major estimates of economic activity and output, such as the GDP, industrial production, and employment. Paying attention to the value and movements in the PMI can yield profitable foresight into developing trends in the overall economy.

The Bottom Line

Investors, economists, and analysts have a wealth of information to help them gauge where the economy is headed. One leading indicator is the Purchasing Managers' Index. Released every month, it is derived from a survey sent out by the Institute for Supply Management to more than 400 companies in various sectors. Responses are compiled and a reading is reported based on how these companies feel about the current economic climate. A high reading indicates positive growth while a low one points to a contraction.