What is proration?

Imagine one of your customers cancels their subscription in the middle of a billing period. What do you do? Make them pay for the entire period that they signed up for or charge them accurately for the services that they used? Prorated billing ensures that your customers are charged fairly and accurately. Find out everything you need to know about proration, including how to prorate fees and why proration in the SaaS space is so important. First off, what does prorated mean?

Prorated definition

Proration sounds complicated, but it’s actually a very simple concept. Essentially, if you use something for less time than you’re scheduled to use it for, it’s fair to expect that you’ll only be charged for the time you used. That’s essentially what we mean by a prorated charge, or prorated amount. Proration is an especially important concept for subscription-based businesses to understand, as many customers will want to change or cancel their subscription plan at some point during a billing cycle.

When is proration used?

Proration can be used whenever your customers change their subscription plan. For example, if a customer downgrades their plan to a less expensive option, they’re likely to have paid more than their expected usage. As a result, they may need to be given prorated credit, because they’re owed cash for the price difference. Of course, if a customer upgrades to a more expensive plan, their monthly bill may need to be increased to reflect the standard of service that they actually received. Prorated billing can ensure that the customer pays the difference.

Example of prorated billing

For a better sense of how prorated billing works in practice, let’s look at an example of how to prorate in the real world. Imagine that a group of customers use Subscription Plan A for the first 15 days of the month, before switching to Subscription Plan B for the remaining 15 days. Prorated billing ensures that the customer pays one price for the first half of the month (the price of Subscription Plan A) and a different price for the other half of the month (the price of Subscription Plan B).

Let’s say that Subscription Plan A costs $300 per month, whereas Subscription Plan B costs $200 per month, and that payment is taken at the beginning of the month. In this example of prorated billing, the prorated amount is $150, the prorated credit is $150, and the charge on the new plan for that month is $100. Consequently, the customer’s bill for that month would result in a credit of $50, and next month’s bill would therefore be $50 less expensive.

Why is proration important?

Because most SaaS products allow customers to make changes to their subscription plan in the middle of a billing cycle, it’s important to have the capacity to align fees with consumption. That way, your customers can be assured that they’ve only paid for the service that they used. It’s a great way to build up customer engagement, boost loyalty, and encourage your customers to re-subscribe in the future. As you may know, customer success plays a significant role in the success or failure of any SaaS business, so learning how to prorate can have a vital impact on your company’s survival.

Tips for how to prorate effectively

Proration isn’t always easy. The math can be complicated, and with customers amending their subscription plans mid-month, signing up days before the end of the billing cycle, and so on, it’s crucial to have a firm grasp of how to prorate before you start sending invoices. Here are some of our top tips for prorated billing:

1. Be transparent with your customers – Ensure that you’re completely transparent about how you prorate charges, explaining very clearly on your invoices how you’ve come to the prorated amount. This ensures that your customers know what they’re being billed for and sets them up to have a positive experience.

2. Track the effect of proration on your revenue – Revenue recognition is a major compliance issue for SaaS businesses, so when you prorate payments, ensure that you’re mindful of the dates when you create a new subscription. Otherwise, you may make a mistake and accidentally record cash from subscriptions as revenue.

3. Utilize a modern payment collection service like GoCardless – With so many different invoices and forms of payment, collecting recurring payments can be a challenge, and prorated billing doesn’t make that challenge any simpler. GoCardless makes it easier to collect recurring payments from customers all over the globe.

We can help

GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.