A portfolio approach to procurement risk management

Abstract

Procurement and replenishment are always susceptible to uncertain customer demand and also to purchase price volatility. Single factor approaches such as long-term contracts, spot procurements, or supply contracts with options, can mitigate some specific aspect of the overall risk, but such approaches are often of limited value when several types of risk prevail. This study contributes to the problem of procurement by presenting a portfolio approach that simultaneously deals with the two major types of procurement risk, price and inventory. The specific model presented jointly considers both the procurement planning and risk hedging problems. The model is in the form of a multi-stage stochastic program in which replenishment decisions are made at various stages along a time horizon, with replenishment quantities being jointly determined by the stochastic demand and the price dynamics of the spot market. The model attempts to minimise the risk exposure of procurement decisions measured as conditional value-at-risk. Numerical experiments to test the effectiveness of the proposed model. The results indicate that the proposed model can fairly reliably outperform other approaches, especially when either the demand and/or prices exhibit significant variability.