Purchase commitment definition
/What is a Purchase Commitment?
A purchase commitment is a firm commitment to acquire goods or services from a supplier. Companies enter into purchase commitments in order to lock in a particular price, and sometimes also to lock in the production capacity of a supplier, which can be used as a defensive tool to keep competitors from using the production capacity.
The commitment may cover purchase orders placed over a broad span of time (known as a master purchase order), or it may only apply to a single purchase to be made. The commitment is usually for a fixed price, or uses a sliding pricing scale, depending on the number of units purchased. A purchase commitment is considered binding on both parties, and so could be used as the basis for a legal action by either one. A legal action is most likely when the price point that the parties have agreed to diverges over time from the market rate, so that one party is placed in a disadvantageous position and wants to terminate the contract. A legal dispute is especially likely when one party expects to be at a pricing disadvantage for an extended period of time.
Documentation of a Purchase Commitment
A purchase commitment is typically documented in the form of a purchase order, on which is stated a specific number of units that a supplier is authorized to ship, along with the price the buyer is authorized to pay, and the date by which the buyer expects delivery.
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Accounting for a Purchase Commitment
If a commitment cannot be cancelled, and is for a specific number of units at a fixed price, the buyer should report a loss if the market price of the items stated in the commitment drop below the price stated in the contract. This loss should be recognized on the period in which the market price drops below the commitment price.
For example, a utility enters into a long-term commitment to buy uranium ore at $75 per pound. The market price is now $60, so the utility should recognize a loss of $15 per pound, multiplied by the number of units remaining to be purchased under the contract. The loss is charged to the Estimated Loss on Purchase Commitment account, with the offsetting credit going to the Estimated Liability on Purchase Commitment account.