What is proration?

It is the process of price adjustment of a product or service based on the amount and quantity used within a given billing period. It is a fair practice that allows customers to be charged for the actual usage of a product/service rather than fully billing when they have not benefitted from full service in the entire period. Proration is majorly applied in businesses that run on subscription-based models, utility items, leases, and other cases where billing must reflect partial usage of a service.

As per subscription-based businesses, proration refers to when a customer starts or cancels a service midway through a billing cycle. As an instance, if a customer subscribes to a service on the 20th of the month, they will be liable to pay for only that part of the month rather than the complete month cycle. In the same way, if they stop using a service by cancelling it on the 20th of the month, they will only be required to pay for the days they used a service.

This concept relies on fairness, as customers are not heavily charged for not using a service or not undercharged if they made plan upgrades. Thus, proration as a concept goes in the customer’s favor, thereby allowing customer satisfaction. Moreover, it enables businesses to keenly check their finances and maintain transparency of monetary matters.

What are the essential requirements for implementing proration?

Implementation of proration requires a billing system that is robust enough to make accurate calculations of the number of days a service has been used within the billing period. This is done by dividing the total cost of the service by the number of billing cycle days to find out the per-day rate and multiplying it by the days the service was accessed. In case of service based on usage quantity, the system can calculate the cost depending on the proportion of total quantity used.

What is the key to seamless services?

Proper communication with customers regarding the proration concept and how it is implemented on the billing cycle can be helpful to maintain transparency. Customers, when aware of how they are being facilitated with their subscriptions, can enjoy clarity of services. It is also important to communicate to them any upgrades/downgrades they availed and how they are charged on that basis. With accurate reflection of partial use and other charges, customers can benefit from brand loyalty and fairness along with financial accuracy of billing cycles.

What is the proration formula?

(Total Amount Used ÷ Total Number of Days) × Proration Period = Prorated Payment

Proration Calculation Example includes:

Let’s say a customer signs up for a monthly software subscription on February 15th, and the full monthly cost is $17.54. Since the customer is only using the service for half the month (15 days), the provider wants to prorate the payment.

Calculating Prorated Payment:

Total Amount Used: $17.54

Total Number of Days: 28 (days in February)

Proration Period: 15 days

($17.54 ÷ 28) × 15 = $7.89

So, the customer should be billed $7.89 for the partial month instead of the full amount ($17.54).

What are the types of proration?

In a subscription billing cycle, there are two types of prorations:

• Partial month proration
• partial year proration

In case of partial month proration, it is calculated by taking the total number of days used in a billing cycle divided by the total number of days in that particular billing cycle. The result is then multiplied against the cost of goods or services to estimate the amount due.

Partial year proration is somewhat the same, but it takes into account the number of days used during a year rather than a single billing cycle. It allows businesses to know the amount due for services used by customers over one year’s span.

What is prorated payment?

Prorated payment is the partial payment that reflects the actual usage of goods or services during a billing period. It is calculated using a two-part formula that takes into account:

1. The number of days the goods or services were used
2. The total cost of the goods or services

The resulting payment amount is a proportion of the total cost, corresponding to the specific usage period.

What is a billing cycle?

It is a billing period, a time interval between two billing statements. In most cases, billing cycles are set at one month, but they can vary based on the services offered. A typical billing cycle lasts between 20 and 45 days. These cycles allow businesses to interpret the time when to charge customers and allow the accounts department to monitor revenue inflows.

How does a billing cycle work?

Billing cycles vary for the type of business; although some companies prefer to begin the billing cycle on the day when an account is opened, others may opt for the billing cycles of all accounts to start on the same date. If the business opts for same-day billing of all accounts, they may prorate the bill for the amount of time before the next billing cycle begins.

After each cycle ends, customers are given a certain amount of time to send in their payments. This period can be referred to as a grace period, and if the subscriber liable to pay fails to make the payment, they may be subject to penalties.

What is a subscription fee?

A subscription fee is the recurring payment made by a customer to regularly access a service or a product. It can either be on a monthly or annual basis, allowing them easy access to features and benefits offered by the company offering subscription-based services. Netflix, Hulu, and Spotify are examples of service-based subscriptions. Subscribers are expected to pay for ongoing access to these on a monthly basis.

What is an invoice?

An invoice is a document that indicates the costs of goods or services offered to a customer along with payment terms. It serves as a request for payment from the customer for the goods/services availed. Among the key components of an invoice are billing information, customer information, invoice number, date, description of goods, quantities and prices, subtotal, taxes and discounts, total amount due, and payment terms.

What is chargeback?

A chargeback is a reversal of a payment or a transaction, initiated by a customer’s bank or credit card issuer, typically due to a dispute or issue with the transaction. Unauthorized transactions, incorrect or defective goods or services, non-delivery of goods, non-processing of credit, or any fraudulent activity can lead to a chargeback.

What is consumption-based billing?

When customers are charged based on their actual use or consumption of a product/service, it is called consumption-based billing. Its key characteristics include pay-as-you-go, variable costs, and metered usage. Some examples of this sort of billing include utility bills, cloud computing, data storage, and telecommunications.

How does proration affect revenue recognition?

Proration affects revenue recognition by ascertaining that revenue is matched with corresponding expenses incurred during the same period. It allows accurate recognition of revenue for partial periods, such as when a customer signs up or cancels mid-month. Moreover, it allows compliance with revenue recognition accounting standards such as ASC 606 or IFRS 15.

What are the benefits and drawbacks of using proration in billing?

Proration allows streamlined invoicing and payments to your accounts without stress. It simplifies the process of billing and charges by offering transparency. Proration enables continued trust in your services by customers as the calculations are exact and accurate. It allows ease of retaining customers and an expanded customer base.

Drawbacks

Implementation of proration can be complicated as it may require configuration and setup. It may require upfront investments in software training and consulting. Proration requires ongoing maintenance for compliance with evolving regulations. Moreover, calculations can be complicated and erroneous if not done accurately. Moreover, proration has limited suitability and is not suited to every type of business niche. Integration challenges may also occur, as it may require integration with the existing billing system, thereby consuming time.

How does proration impact customer invoices?

Accurate invoicing: Proration ensures that customers are invoiced accurately for the services they’ve used, reducing errors and disputes.

Adjusted invoice amounts: It adjusts invoice amounts to reflect the actual usage or subscription period, which can result in partial-month charges.

Clear breakdown of charges: It provides a clear breakdown of charges on the invoice, showing the prorated amount and any applicable taxes or fees.

How do you automate proration calculations in a billing system?

Automating proration calculations in a billing system can be achieved by:

Determining proration methods: Choose from various proration methods such as calendar day, linear, and 30-day month.

Set up proration triggers: Define triggers such as subscription changes, downgrades, or upgrades.

Setup parameters: Set parameters for proration such as invoice dates, billing cycles, and payment terms.

Billing system: Opt for a billing system that supports automation, such as a cloud-based subscription billing platform.

Configure proration settings: Configure proration settings within the billing system, including rules, triggers, and parameters.

Integrate with payment gateways: Integrate the billing system with payment gateways to automate payment processing.