What is proration?
Proration, also called usage-based billing, is the process of adjusting the amount a customer is charged for a subscription, so the customer only pays when they use the service. This method is necessary for subscription-based businesses, as customers often begin or end a subscription in the middle of a billing period.
Without this billing strategy, customers would have to pay for the entire month. With it, they pay only for the services they use.
Proration is also used when customers upgrade or downgrade their subscription in the middle of a billing cycle. This alternate strategy is necessary to ensure accurate billing, as long as the customer’s subscription price becomes more or less than what they already paid.
Organizations use subscription billing software to manage recurring billing when offering subscription-based products and services. These tools generate invoices for various subscription plans and billing frequencies.
Proration benefits
Proration is beneficial to both customers and businesses. By prorating bills, companies can:
- Charge customers fairly. Prorating charges allows businesses to charge customers only for the services they use. This helps customers feel they are getting what they pay for.
- Allow changes mid-billing cycle. Proration allows customers to shift payment tiers in the middle of a billing cycle. If they move to a more expensive subscription tier, they only have to pay the additional charge for the days that remain in the billing cycle. If they downgrade, they are refunded the difference for the remaining days.
- Increase customer satisfaction. When customers pay only for what they use, they’re more inclined to feel supported by and satisfied with the company and less likely to feel taken advantage of.
- Reduce customer churn: The flexibility offered to customers who want to change their subscription as needed can reduce the customer churn rate. When customers wish to upgrade or downgrade their tier, they can easily do so without canceling or taking a break.
Basic elements of proration
Proration processes involve an easy formula, standard policies, and invoices.
- Formula: The billing strategy is most commonly calculated by dividing the subscription fee by the number of days in the billing cycle. Then, this number is multiplied by the number of days the customer uses the service.
Proration = monthly fee/days in billing cycle x number of days spent using the product
If the service costs $30 per month and the customer cancels after 15 days, the equation would be $30/30 days x 15 days = $15.
- Invoices: Invoices should reflect proration calculations, showing customers exactly how the sum they are being charged was calculated.
- Refunds: When a customer ends their subscription or downgrades after paying the subscription fee upfront, refunds are issued to the customer for the remaining days in the billing cycle.
- Revised charges: When a customer upgrades their subscription midway through the billing cycle, they may have to pay an additional fee to compensate for the difference in subscription tier costs.
- Proration policy: Organizations should define a policy that communicates what circumstances warrant prorated billing.
Proration best practices
Proration can be transformational for customer satisfaction, but only when done right. Best practices for prorating bills include:
- Transparency: Businesses must be transparent with customers about how these charges are handled. Invoices should clearly outline how the prorated amount was calculated. This ensures the customer trusts they are paying the correct amount every time.
- Revenue recognition: Because revenue recognition is vital to SaaS businesses' compliance, prorated payments must be documented in detail to report revenue correctly.
- Using the right tools: Accurately prorating and documenting payments by hand is extremely difficult. The right software simplifies collecting invoices, managing different forms of payment, collecting recurring payments, and prorating bills when necessary.
Martha Kendall Custard
Martha Kendall Custard is a former freelance writer for G2. She creates specialized, industry specific content for SaaS and software companies. When she isn't freelance writing for various organizations, she is working on her middle grade WIP or playing with her two kitties, Verbena and Baby Cat.
