The procurement of strategic parts. Analysis of a portfolio of contracts with suppliers using a system dynamics simulation model

In this paper, we present a simulation study to extend current methods for real options strategies in the management of strategic commodity-type parts. Real options are used by procurement and financial managers to secure price and availability in the face of volatile world demand. We define, characterize and simulate three generic types of supplier contracts to accomplish varying degrees of security and flexibility. We then simulate a portfolio of these contracts applied to secure a single part, with the purpose of extending and refining portfolio valuation. We focus our attention on business dynamics based on current best practices in portfolio management, as evidenced by leaders in volatile technology businesses. The strategic part procurement system, as modeled here, includes in-transit and warehoused inventories to accommodate demand variability as well as asynchronous production and shipping lead times. In addition, the portfolio structure itself periodically creates excess inventory as negotiated terms and policies are executed in various conditions. Given these inventories and related costs, we show how optimization techniques can be used to measure the tradeoffs between alternative portfolio structures. A modified Powell method is used to carry out these optimizations properly. Finally, we describe how this more complete valuation of the portfolio is critical to option pricing models, with the ultimate potential for indexing as seen in other commodity markets. (C) 2003 Elsevier B.V. All rights reserved.