A Continuous-Review Inventory Model: Harnessing the Spot and Futures Price Cointegration for Effective Cost Control

The volatile commodity price nowadays poses a great challenge to the effective control of cost in inventory management. Empirical studies have suggested that such a spot price volatility is significantly cointegrated to the price variability in commodity futures market. This paper therefore proposes a novel approach that can take advantage of such cointegration using a continuous review inventory model. It is shown that the optimal procurement strategy of the non-perishable commodity can then be characterized by a sequence of continuation regions, i.e., two-dimensional areas in the state space, which indicates when the manager should continue waiting for a better time for commodity procurement. One unique feature of this continuation-region-based strategy is that it optimally utilizes price information from both the commodity spot and futures markets to achieve effective cost control. Through numerical analysis, we corroborate the necessity of incorporating the futures price information into commodity procurement.