Time is money. But what happens when a customer uses your services for less than the standard amount of time? Most companies choose to charge a prorated amount.
What is the meaning of “proration,” exactly? Here's everything you need to know about proration and how to calculate proration for your customers or employees.
What does prorated mean?
To prorate means to adjust the cost of something to reflect only the price of what is used.
For example, say your business has a subscription service that bills at the beginning of each month. If a customer subscribes on the 15th, keeping them on the hook for the whole month’s new subscription amount would be overcharging. In such cases, you would prorate, meaning the customer would only be responsible for the percentage of the time they’ve used the service.
Because proration reflects an actual time and not the full theoretical duration stipulated in a contract, it can be helpful when managing bookkeeping, particularly when a customer's experience only partially aligns with your billing cycle.
What are prorated charges?
Customers may ask about prorated charges if your company offers a subscription service.
Despite the simplicity of this approach, it's unlikely that your customers will consider it fair. Some may even deliberately time their subscriptions to score a "free" service period.
For example, imagine you charge your customers an annual fee for a subscription to your company's services. If someone has been a customer for less than a year, you can offer them a prorated fee corresponding to the actual time they've used your services when it comes time to bill them.
When is prorating used?
Many different industries prorate their service costs. Here are a few of the most common examples of when a business might prorate its costs or even its employees' salaries.
Rent
Landlords typically charge by the month, but business tenants don't always move in on the first. Consequently, landlords might prorate the rent, setting a "pro rata" amount equal to the days the tenant rented the property.
Utility bills
Like real estate landlords, utility companies generally charge by the month. This includes electricity, water, cable, and internet providers. If you or your business only start using these services in the middle of the month, for example, your provider may prorate your bill, reducing your fees to reflect the duration you used these services.
To be clear, utility companies won't prorate your bill if you connect to their services but don't physically occupy the rental unit or commercial real estate space. Instead, they'll typically start charging when your services are first connected.
Paying contractors
Business owners can also prorate what they pay their employees and contractors.
If you recently hired an employee and they start in the middle of the month, you can prorate their pay so that they are only paid for the days they worked that month rather than the entire month.
As for contractors, if you charge a contractor to work for a set amount of time, you can arrange for a prorated amount based on the time they actually spend working. If you hire a contractor for a month, but they finish the project sooner, you'd only pay for the time they spent working.
Make sure to reach a clear agreement with your contractor before they begin working. Only some contractors will accept prorated compensation, so do your best to respect your contractors' time and ensure you’re paying them per your initial agreement.
Some contractors deliberately prorate their services to secure business, so this can be a convenient way to ensure quality work while also keeping costs down.
Upgrades in subscription services
In an age where software is increasingly offered as a service (SaaS), it's not unusual for companies to charge varying rates depending on the features and plan a customer chooses to purchase.
For instance, you might have a customer currently using the "basic" level of your software program — they've paid for a monthly or even yearly subscription upfront, but along the way, they decide to upgrade to your "premium" content.
Rather than charge the full amount of these premium features, you can charge a prorated amount proportional to the amount of time remaining on their original contract and the price difference when migrating from basic to premium service.
Why is proration important?
Proration is important for your business because it ensures your customers are fairly treated. Here are a few ways proration can help you connect with your customers.
Helps you build trust
First, prorated services are simply fairer. If a customer only uses your services for a portion of the standard contract, it only makes sense to charge them a rate that reflects their experience with your company.
Advertising prorated services can make your business more trustworthy in the eyes of potential customers and give them greater confidence in their chosen services.
Allows your business to be flexible
Prorating your digital content or software services can afford your customers greater flexibility.
For instance, a customer might be torn between your "basic" and "premium" software subscription packages. Prorating the cost of an upgrade might encourage them to sign up for the more affordable package now, only to later shell out for the complete range of features.
Similarly, if you're a landlord, prorating your tenants' rent can give them more freedom when moving in and out. This freedom can give you an edge over potential competitors who expect renters to abide by a strict calendar and billing cycle.
Builds customer loyalty
Prorating a customer's bill today could pay off tomorrow. When customers know they'll be charged a fair rate, they may be more willing to renew their subscriptions or continue relying on your business services.
Prorating benefits
Offering prorated services can benefit both you and your most loyal customers in several ways.
Benefits for customers
Customers appreciate prorated services and rental agreements because they:
- Offer lower prices for partial use of the services or property
- Provide flexibility regarding moving in or starting a new subscription
- Ensure fair, transparent billing practices
In other words, your customers may expect prorated fees. Providing them can satisfy these expectations, which in turn can build customer loyalty.
Benefits for businesses
Prorating your customers' bills can also benefit your company. That's because it:
- Promotes customer loyalty and subscription renewals
- Offers flexibility that distinguishes you from competitors
- Satisfies customer expectations
Prorating can therefore give your business a boost and improve positive brand associations among your existing and future customers.
Disadvantages of prorating
As useful as prorating can be, it has some drawbacks. Here are a few possible disadvantages of prorating your customer charges:
- It can reduce your incoming cash flow
- It necessitates extra calculation and bookkeeping
- Customers may not understand proration
- Not every business can prorate its services
Despite these downsides, most companies will find that the benefits of proration far outweigh any possible disadvantages. In fact, failure to prorate your core services could even cause potential customers to jump ship and seek a competitor able to offer a more affordable, flexible option.
How to calculate a prorated amount
Here's how you can calculate a proportional settlement for your customers and employees.
Imagine you charge your customers $75 per month for your services. What happens if a customer joins in the middle of the month? Here's how to calculate prorated charges they owe:
- Take the monthly rate and divide it by 30 to get the amount per day
- Multiply the rate per day by the number of days to get the prorated sum
For example, imagine that Sarah starts using your services on the twenty-first of the month. How much would you charge her based on the formula mentioned above? Here's how it works out:
- The daily rate is $2.50 ($75 divided by 30 days)
- Sarah has used your services for 21 days, so she owes $52.50 ($2.50 multiplied by 21)
That's it! You can use this basic formula to prorate any monthly amounts you wish to adjust for your customers or renters.
How to calculate prorated payments
What about prorated payments? For example, let's say you have an employee who works for $15.00 per hour, but their shift only lasts 42 minutes. In this case, the method is largely the same as above:
- Take the hourly rate and divide by 60 to get the amount per minute
- Multiply the rate per minute by the number of minutes to get the prorated sum
Using the example above, you'd arrive at the following conclusions:
- The amount per minute is $0.25 ($15/60 minutes)
- You therefore owe the employee $10.50 ($0.25 x 42 minutes)
As before, you can use this formula to proportionately figure any hourly rate for workers.
Alternatives to prorating
Admittedly, prorating involves an extra step, which some high-volume businesses understandably might want to avoid. Here are some possible alternatives, along with some pros and cons.
Rounding up (or down)
You could round subscription costs to the nearest day or month depending on your industry. For instance, if a customer subscribes before the 15th of the month, you'd charge them for the full month. But if they subscribe after this date, you'd charge them nothing.
Paying the full amount
When it comes to paying your employees or contractors, it might promote goodwill to round their time up to the nearest hour and pay them accordingly. But if this becomes a standard policy, employees could start clocking out early with no penalty.
Creating individualized billing cycles
Subscription-based companies might simply tailor their billing cycle to each customer — if a customer signs up on the 17th of the month, their billing cycle will last until the 17th of the next month. This strategy eliminates the need to prorate, but it demands that you stay organized and keep up with every customer's unique billing period.
Tips for effective prorating
How can you make proration a practical part of your business strategy? Follow these simple tips to help you charge fair prices and maintain strong customer relationships.
1. Be consistent
Stick to your proration formula, apply your proration policy uniformly across the board, and if you prorate a service for one customer, make sure you offer the same benefit to all of your other customers.
2. Be transparent
Make sure your customers understand your proration policy upfront, preferably before you enter into any sort of contract.
Your invoices should likewise reflect this policy, and line items should lay out how your company arrived at the prorated amount. This will prevent any possible confusion and let your clients know what to expect in the future.
3. Keep track of your prorated charges
When you offer subscriptions and other ongoing services, you'll want to distinguish between revenue and the cash flow you generate from subscriptions. Keeping clear, detailed records will ensure that you comply with revenue recognition policies, a must for any SaaS business.
4. Go digital
Using a digital platform can equip you to monitor payments and cash flow and help you distribute invoices and other essential documents to your clients. The right financial platform can streamline the process while offering advanced reporting and analytical tools that help you integrate subscriptions into your broader business strategy.
Get equipped with BILL
With BILL, you'll have access to some of the most advanced resources in the financial industry. Send invoices, stay organized, and get paid faster than ever before. Sign up for BILL today and take 30 days to explore our suite of services risk-free.
