Integrating Spot and Futures Commodity Markets in the Optimal Procurement Policy of an Assemble-to-Order Manufacturer

Manufactures often rely on different types of long term contracts with established suppliers to procure goods often involving delivery lead times; however, the emergence of online B2B markets provides an additional procurement flexibility. Manufacturers can interact directly with the market either through spot transactions or claims contingent on commodity prices. In particular, we explore the value of incorporating the convenience yield at market equilibrium (under a rational expectations assumption) in procurement decision making for different sourcing configurations. Although the concept of convenience yield has not been explored in the supply chain management literature, it is very well developed in finance literature. In this research we model the manufacturer as a price taker, and model commodity prices using a two factor (spot price and instantaneous convenience yield) continuous time, arbitrage free, stochastic process. The manufacturer’s decision making process is modeled through a discrete time stochastic dynamic program that samples spot price and convenience yield information from the above continuous time stochastic process. We also model transaction cost in the procurement process from spot and futures market. Our analysis suggests that, apart from risk reduction, the potential savings in transaction cost in the futures market entices manufacturers to procure some fraction of goods from these markets. Intuitively, the higher the convenience yield for a commodity, the more expensive it becomes for a manufacturer to overstock, leading to lower service levels and lower demand fill rates. Finally, our numerical results show that it is possible to decrease inventory related costs by up to 30% on incorporating market convenience yield information. (B2B exchange, convenience yield, futures contract, commodity market) ∗University of Texas Austin, Management Department CBA 4.202 Austin TX78712, [email protected] †University of Texas Austin, Management Department CBA 4.202 Austin TX78712, [email protected] 1