# Inventory control in dual sourcing commodity procurement with price correlation

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## Abstract

In this paper, we focus on the role of inventory management as a means for operational hedging by dual sourcing of commodities using a multi-period option contract and spot market. We consider a manufacturing company in a make-to-stock environment with uncertain product demand. We replace the common i.i.d. price assumption that is typical in operations management studies by the mean reverting price model, a more realistic spot price model with inter-temporal price–price correlation. Additionally, we address the case where the spot price in one period is correlated with the demand in the previous period (demand–price correlation). The contribution of the paper is threefold. First, we reveal that price–price correlation has a considerable impact on the structural properties of optimal stock-keeping policies. Furthermore, we isolate two main effects of correlation in spot-price dynamics when selecting policy parameters: a variability effect, which increases the benefits from stock-keeping and lessens the usage of the option contract, and a counteracting correlation effect that exploits persistence of low/high spot price incidences. Finally, in a numerical study we show under which circumstances disregarding the correlation can result in large performance losses.

## Keywords

Stochastic programming Dynamic programming Inventory theory and control Capacity planning and investment## References

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