A Portfolio Approach to Procurement Contracts

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Abstract
The purpose of this paper is to develop a general framework for supply contracts in which portfolios of contracts can be analyzed and optimized. We focus on a multi‐period environment with convex contract, spot market, and inventory holding costs. We specialize the model to the case of a portfolio consisting of option contracts. We characterize the optimal replenishment policy and show that it has a simple structure. Namely, the use of every different option contract and the spot market is dictated by a modified base‐stock policy. In addition, we derive conditions to determine when an option is relatively attractive compared to other options or the spot market. Finally, we present our computational study, where we report the sensitivity of the results to the parameters of the model. Our experiments indicate that portfolio contracts not only increase the manufacturer's expected profit, but can also reduce its financial risk.