Index Numbers and Ratios

When facing a lack of a unit of measure, we often use indicators as surrogates for direct
measurement. For example, the height of a column of mercury is a familiar indicator of
temperature. No one presumes that the height of mercury column constitutes temperature
in quite the same sense that length constitutes the number of centimeters from end to end.
However, the height of a column of mercury is a dependable correlate of temperature and
thus serves as a useful measure of it. Therefore, and indicator is an accessible and
dependable correlate of a dimension of interest; that correlate is used as a measure of that
dimension because direct measurement of the dimension is not possible or practical. In
like manner index numbers serve as surrogate for actual data.
The primary purposes of an index number are to provide a value useful for comparing
magnitudes of aggregates of related variables to each other, and to measure the changes
in these magnitudes over time. Consequently, many different index numbers have been
developed for special use. There are a number of particularly well-known ones, some of
which are announced on public media every day. Government agencies often report time
series data in the form of index numbers. For example, the consumer price index is an
important economic indicator. Therefore, it is useful to understand how index numbers
are constructed and how to interpret them. These index numbers are developed usually
starting with base 100 that indicates a change in magnitude relative to its value at a
specified point in time.
For example, in determining the cost of living, the Bureau of Labor Statistics (BLS) first
identifies a"market basket" of goods and services the typical consumer buys. Annually,
the BLS surveys consumers to determine what they buy and the overall cost of the goods
and services they buy: What, where, and how much. The Consumer Price Index (CPI) is
used to monitor changes in the cost of living (i.e. the selected market basket) over time.
When the CPI rises, the typical family has to spend more dollars to maintain the same
standard of living. The goal of the CPI is to measure changes in the cost of living. It
reports the movement of prices, not in dollar amounts, but with an index number.

Consumer Price Index

The simplest and widely used measure of inflation is the Consumer Price Index (CPI). To
compute the price index, the cost of the market basket in any period is divided by the cost
of the market basket in the base period, and the result is multiplied by 100.
If you want to forecast the economic future, you can do so without knowing anything
about how the economy works. Further, your forecasts may turn out to be as good as
those of professional economists. The key to your success will be the Leading Indicators,
an index of items that generally swing up or down before the economy as a whole does.
Period 1

Period 2

Items

q1 =
p1 =
q1 =
p1 =
Quantity Price Quantity Price

Apples

10

$.20

$.25

Oranges

$.25

11

$.21

we found that using period 1 quantity, the price index in period 2 is

($4.39/$4.25) x 100 = 103.29
Using period 2 quantities, the price index in period 2 is
($4.31/$4.35) x 100 = 99.08
A better price index could be found by taking the geometric mean of the two. To find the
geometric mean, multiply the two together and then take the square root. The result is
called a Fisher Index.
In USA, since January 1999, the geometric mean formula has been used to calculate most
basic indexes within the Comsumer Price Indeces (CPI); in other words, the prices within
most item categories (e.g., apples) are averaged using a geometric mean formula. This
improvement moves the CPI somewhat closer to a cost-of-living measure, as the
geometric mean formula allows for a modest amount of consumer substitution as relative
prices within item categories change.
Notice that, since the geometric mean formula is used only to average prices within item
categories, it does not account for consumer substitution taking place between item
categories. For example, if the price of pork increases compared to those of other meats,
shoppers might shift their purchases away from pork to beef, poultry, or fish. The CPI
formula does not reflect this type of consumer response to changing relative prices.

Ratio Index Numbers

The following provides the computational procedures with applications for some Index
numbers, including the Ratio Index, and Composite Index numbers.
Suppose we are interested in the labor utilization of two manufacturing plants A and B
with the unit outputs and man/hours, as shown in the following table, together with the
national standard over the last three months:

Months

Plant Type - A
Unit
Man Hours

Unit

Plant Type - B
Man Hours

Output
0283

200000

Output
11315

0760

680000

300000

12470

720000

1195

530000

13395

750000

Standard

4000

600000

16000

800000

The labor utilization for the Plant A in the first month is:
LA,1 = [(200000/283)] / [(600000/4000)] = 4.69
Similarly,
LB,3 = 53.59/50 = 1.07.
Upon computing the labor utilization for both plants for each month, one can present the
results by graphing the labor utilization over time for comparative studies.
You might like to use the Index Numbers JavaScript to check your hand computation.

Composite Index Numbers

Consider the total labor, and material cost for two consecutive years for an industrial
plant, as shown in the following table:
Year 2000
Year 2001
Labor
Almunium
Electricity
Total

Unit Needed
20
02
02

Unit Cost
10
100
50

Total
200
200
100
500

Unit Cost
11
110
60

Total
220
220
120
560

From the information given in the above table, the index for the two consecutive years
are 500/500 = 1, and 560/500 = 1.12, respectively.
Further Readings:
Watson C., P. Billingsley, D. Croft, and D. Huntsberger, Statistics for Management and Economics, Allyn & Bacon, Inc.,
1993.

Variation Index as a Quality Indicator

A commonly used index of variation measure and comparison for nominal and ordinal
data is called the index of dispersion:
D = k (N2 - fi2)/[N2(k-1)]

where k is the number of categories, fi is the number of ratings in each category, and N is
the total number of rating. D is a number between zero and 1 depending if all ratings fall
into one category, or if ratings were equally divided among the k categories.
An Application: Consider the following data with n = 100 participants, k = 5 categories,
f1 = 25, f2 = 42, and so on.
Category
A
B
C
D
E

Frequency
25
42
8
13
12

Therefore the dispersion index is: D = 5 (1002 - 2766)/[1002(4)] = 0.904, indicating a

good spread of scores across the categories.
You might like to use the Index Numbers JavaScript to check your hand computation.

Labor Force Unemployment Index

Is a given city an economically depressed area? The degree of unemployment among
labor (L) force is considered to be a proper indicator of economic depression. To
construct the unemployment index, each person is classified both with respect to
membership in the labor force and the degree of unemployment in fractional value,
ranging from 0 to 1. The fraction that indicates the portion of labor that is idle is:
L = [UiPi] / Pi, the sums are over all i = 1, 2,, n.
where Pi is the proportion of a full workweek for each resident of the area held or sought
employment and n is the total number of residents in the area. Ui is the proportion of Pi
for which each resident of the area unemployed. For example, a person seeking two days
of work per week (5 days) and employed for only one-half day would be identified with
Pi = 2/5 = 0.4, and Ui = 1.5/2 = 0.75. The resulting multiplication UiPi = 0.3 would be the
portion of a full workweek for which the person was unemployed.
Now the question is What value of L constitutes an economic depressed area. The answer
belongs to the decision-maker to decide.

The Body Mass Index:

Are you overweight/underweight?

The Body Mass Index (BMI) serves as an estimate of body composition. That is the ratio
of fat to muscle and bone based on your height and weight. BMI model is the ratio of the
weight (kilograms) to the height (meters) squared. i.e.:
BMI = weight / height2.
This model is valid for both men and women 18 years of age or older. The BMI is
believed to be a reliable indicator of total body fat, which is related to the risk of disease
and death. Statistics has shown that obesity-related causes of death in the U.S. are over 16
percent of all deaths.
Body Fat Test: Since the BMI may overestimate for people who have a muscular build
and underestimate for people who have lost muscle mass, therefore, a more accurate tool
is the Body Fat Test that performed by your physician.
The following table provides a generally accepted classification:
A Classification of Body Mass Index (BMI)
Underweight

BMI less than 18.5

Normal weight BMI 18.5 to 24.9

Overweight

BMI 25 to 29.9

Obese

BMI 30 or greater

You might like to use the Index Numbers JavaScript to check your hand computation.

Seasonal Index and Deseasonalizing Data

Seasonal index represents the extent of seasonal influence for a particular segment of the
year. The calculation involves a comparison of the expected values of that period to the
grand mean.
We need to get an estimate of the seasonal index for each month, or other periods such as
quarter, week, etc, depending on the data availability. Seasonality is a pattern that repeats
for each period. For example annual seasonal pattern has a cycle that is 12 periods long,
if the periods are months, or 4 periods long if the periods are quartets.
A seasonal index is how much the average for that particular period tends to be above (or
below) the grand average. Therefore, to get an accurate estimate for it, we compute the
average of the first period of the cycle, and the second period, etc, and divide each by the
overall average. The formula for computing seasonal factors is:

Si = Di/D,
where:
Si = the seasonal index for ith period,
Di = the average values of ith period,
D = grand avrage,
i = the ith seasonal period of the cycle.
A seasonal index of 1.00 for a particular month indicates that the expected value of that
month is 1/12 of the overall average. A seasonal index of 1.25 indicates that the expected
value for that month is 25% greater than 1/12 of the overall average. A seasonal index of
80 indicates that the expected value for that month is 20% less than 1/12 of the overall
average.
Deseasonalizing Process: Deseasonalizing the data, also called Seasonal Adjustment is
the process of removing recurrent and periodic variations over a short time frame (e.g.,
weeks, quarters, months). Therefore, season variations are regularly repeating movements
in series values that can be tied to recurring events. The Deseasonalized data is obtained
by simply dividing each time series observation by the corresponding seasonal index.
Almost all time series published by the government are already deseasonalized using the
seasonal index to unmasking the underlying trends in the data, which could have been
caused by the seasonality factor.
A Numerical Application: The following table provides monthly sales ($000) at a
college bookstore.
M

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Total

196

188

192

164

140

120

112

140

160

168

192

200

1972

200

188

192

164

140

122

132

144

176

168

196

194

2016

196

212

202

180

150

140

156

144

164

186

200

230

2160

242

240

196

220

200

192

176

184

204

228

250

260

2592

Mean:

208.6 207.0 192.6 182.0 157.6 143.6 144.0 153.0 177.6 187.6 209.6 221.0

Index:

1.14

1.14

1.06

1.00

0.87

0.79

0.79

0.84

0.97

1.03

1.15

2185

1.22

12

The sales show a seasonal pattern, with the greatest number when the college is in session
and decrease during the summer months. For example, for January the index is:
S(Jan) = D(Jan)/D =208.6/181.84 = 1.14,
where D(Jan) is the mean of all four January month, and D is the grand mean of all past
four years sales.
You might like to use the Seasonal Index JavaScript to check your hand computation. As
always you must first use Plot of the Time Series as a tool for the initial characterization
process.

For testing seasonality based on seasonal index, you may like to use Test for Seasonality
JavaScript.
For modeling the time series having both the seasonality and trend components, visit the
Business Forecasting site.

Statistical Technique and Index Numbers

One must be careful in applying or generalizing any statistical technique to the index
numbers. For example, the correlation of rates raises the potential problem. Specifically,
let X, Y, and X be three independent variables, so that pair-wise correlations are zero;
however, the ratios X/Y, and Z/Y will be correlated due to the common denominator.
Let I = X1/X2 where X1, and X2 are dependent variables with correlation r, having mean
and coefficient of variation m1, c1 and m2, c2, respectively; then,
Mean of I = m1 (1-rc1c2 + c22)/m2,
Standard Deviation of I = m1(c12 - 2 rc1c2 + c22) /m2