For processors, productivity gains make forecasting more difficult

From an economics perspective, now is my favorite time of year. This is the start of the planning and budgeting cycle for 2018.

It is the time when requests from business owners and senior managers for data, charts and forecasts for the plastics industry increase substantially. For my line of work, it is the time when (I couldn't think of an appropriate plastics metaphor to use here) the rubber hits the road.

Because the uses in our economy for plastics are so diverse, these owners and managers will ask for a wide variety of data. But there are two charts they universally want to share with their respective investors, boards of directors and other senior management. These graphs are derived from data provided by the Federal Reserve Board every month. They are the charts for U.S. industrial production and the capacity utilization rate for plastics products.

These charts are always interesting, but this year they are more interesting than usual. To provide some historical context, I have included the past decade's worth of data, but the portions of these charts I want to focus on is the past 2½ years — from 2015 through the present.

If you look closely at the industrial production chart, you can discern that the slope of the graph during this period is slightly upward. More specifically, the annual growth rates were 1.9 percent in 2015, 0.5 percent in 2016 and 0.9 percent for the year-to-date in 2017. That works out to an average annual rate in the range of 1 percent. Certainly not as fast as we would like, but that's how the overall industry performed.

Typically, one would expect capacity utilization to correlate with production. In other words, if output levels increased moderately, then the utilization rate should also increase modestly. And, most of the time, this relationship shows positive correlation.

But not this time, and that is what's interesting about the data. The trend in the rate of capacity utilization since the beginning of 2015 is clearly downward by about three percentage points — from approximately 83 percent to about 80 percent. Now a word of caution is in order here: do not get too hung up by the actual figures. These are overall averages for the industry, and they do not accurately represent any particular industry segment. It is similar to the idea that the average American family has 2.5 children.

It is the trends in these two data series that are important for our purposes of analysis and forecasting, and these trends are moving in opposite directions. What is this telling us?

In my opinion, the best way to describe this is productivity gains. Data from the plastics machinery sector indicate that processors have invested a substantial amount of money in new equipment in recent years. Because of rapid advances in technology, new equipment is much more efficient than the equipment that is getting replaced.

In fact, my own historical analysis leads me to believe that the plastics industry has been getting more productive by an average rate of 3 to 4 percent per year for at least the past 25 years. In other words, market demand must increase by 3 to 4 percent on a sustained basis in order to push the capacity utilization rate higher. If market demand grows slower than this, like it has for the past two and a half years, then the industry will meet this demand with improvements in efficiency that come from just replacing the existing capital stock and there is no need for any expansion.

So not only is it useful to know that the graph is going up and to the right, but it is also important to know what the slope of the graph is. This information will have a profound impact on next year's plans for hiring, capital spending and marketing. And this information is especially crucial if you are in the business of supplying or financing new plants or equipment. This is what makes the industry so exciting, but it also oftentimes makes it difficult to manage. There is no off-season; the strategic planning process never really ends.

Thus, it's not hard to understand why these data series are so popular. They provide an excellent overview of the current state of the plastics industry. Everybody wants to be involved in an industry where the graph is moving up-and-to-the-right. Business, by its very nature, is a forward-looking endeavor. But the future is best seen through the lens of the past. That is why we keep statistics.

Most of the time, recent trends are a good indicator of the activity levels that will prevail in the coming months and quarters. This is often called the foreseeable future, and the managers who handle foreseeable risks appropriately tend to enjoy the most success in the long run.

Everybody also wants to be above-average, but we all know that's mathematically impossible. So by comparing data from a particular company against the industry data, managers and investors can find out if the company's performance is beating the index.

Competition is the essence of capitalism, and nobody is doing this as a hobby. The main thing you are trying to make in your plant every single day is not actually pipe or film or molded parts; it is profit. And if your particular graph is not going up and to the right faster than the industry as a whole, then folks in the boardroom will likely want to know why it isn't.