TABLE OF CONTENTS
- What Is a Prorated Charge?
- How Does Prorated Billing Work?
- How to Prorate a Bill: Prorated Charge Example
- What Business Types Benefit from Prorated Billing?
- Why Is Prorated Billing Important?
- Advantages of Prorated Charges
- Challenges of Prorated Charges
- Effective Strategies for Prorating Accurately
- Frequently Asked Questions (FAQs) on Prorated Billing
Whether you’re a small startup or a large corporation, billing is an essential aspect of any business. However, today’s businesses often feature unique pricing plans, subscription models, and tiered memberships that require more complex charges. This is where prorated fees and billing can be helpful. With a prorated charge, business owners get compensated for products and services based on the exact time period used by the customer. Although it’s a simple and straightforward unit formula, new business owners may be confused as to what prorated billing is, how to calculate it, and why it’s such an effective billing strategy for integrating modern payment processing systems.
What Is a Prorated Charge?
Prorated billing is a method of charging customers that applies fees for partial usage of a product or service during a billing period. This method is commonly used in subscription-based industries (such as software as a service or SaaS telecommunications, as well as basic utilities, housing, and real estate) where recurring billing is common. In other words, rather than a fixed monthly fee, a prorated charge reflects no more and no less than what a customer uses.
How Does Prorated Billing Work?
Prorated billing involves a straightforward calculation that finds the cost-per-day, or cost-per-hour, for your product or service, and then charges the customer for just those number of days or hours that they use your service. For example, if you moved into a new office building on the 5th of the month instead of the 1st, your landlord may offer to subtract four day’s worth of “rent” from your first housing payment.
Proration is particularly popular for subscription-based companies that often rely on yearly or monthly recurring revenue, as well as allow customers to change their subscriptions more frequently than once per year. Proration fees make sense for those customers as then they don’t have to pay the full yearly amount.
Calculating prorated fees for thousands of monthly subscribers at a time can take significant resources and staffing for businesses. This is why it’s common for businesses to use revenue recognition software instead of manually doing the work themselves, and it’s also common to use a merchant service provider that does this work for you.
How Prorated Charges Are Calculated
Prorated billing calculates customer charges for a partial customer billing period. The basic formula for prorated billing is:
Prorated Charge = (Total Price / Total Days in Billing Period) × Number of Days Used
‘Total Price’ is the standard price of the product or service in a full billing period, like the monthly fee. ‘Total Days in Billing Period’ represents days in a typical billing period, usually a month of 30 or 31 days. The ‘Number of Days Used’ refers to the days the customer used the product or service in the current billing period.
How to Prorate a Bill: Prorated Charge Example
Imagine you subscribe to a streaming service that costs $10 per month, and your billing cycle starts on the 1st of every month. If a customer subscribed on the tenth day of the month, they haven’t used the service for the entire 30 days. Therefore, you’ll prorate the billing period. By plugging these values into the formula above, you can calculate the prorated charge. In the case of a customer using a streaming service for ten days of the month, the formula would be:
Prorated Charge = ($10 / 30) × 10 = $3.33
In this case, you would charge the customer $3.33 for their partial usage during their billing period.
What Business Types Benefit from Prorated Billing?
A prorated billing model can benefit all sorts of businesses for customers joining mid-cycle, especially those in the following categories:
- eCommerce subscriptions and subscription-based services: SaaS, streaming platforms, gym memberships, and service subscriptions.
- Hourly or usage-based services: Consulting freelancer fees, utilities, and car rentals.
- Event & venue rentals: Co-working spaces, hotels, hospitality, and event spaces.
- Telecommunications, cloud-based, and internet services: Hosting services.
- Membership organizations: Associations, clubs, and professional societies.
Why Is Prorated Billing Important?
Proration is an important billing model to understand and use if you want to enhance fairness and transparency around your pricing structure. Additionally, it offers customers a way to “pay for what you use,” fostering greater understanding, customer satisfaction, and even better accounting accuracy in your business. Businesses with subscription-based, hourly, or usage-driven models will find proration particularly handy, useful, and important within their business dealings.
Advantages of Prorated Charges
Prorated billing ensures customers pay a fair amount based on actual usage. It eliminates overcharging or undercharging, providing transparency in billing practices. Customers appreciate this fairness, which can lead to increased trust and satisfaction.
For businesses, prorated billing can optimize revenue streams. Instead of waiting for a full billing cycle to start earning revenue from a new customer, businesses can earn income from the moment the customer subscribes. This can improve cash flow and a business’s overall financial health.
Prorated billing can be a powerful tool for customer retention. It allows customers to start using a service immediately without having to wait for the beginning of a billing cycle. This can make it easier for them to evaluate the service and decide if it meets their needs.
Lastly, businesses can use prorated billing to offer a variety of subscription models such as monthly, quarterly, or annual. This flexibility caters to different customer preferences and can attract a wider range of clients.
Challenges of Prorated Charges
Businesses that use proration must ensure their billing systems can accurately calculate prorated charges for all their subscription models. This can get complex and may require significant development and testing if not properly explained. It’s also challenging because some customers find this type of billing confusing.
Effective Strategies for Prorating Accurately
Prorated hourly billing offers fairness and transparency for both service providers and customers by aligning charges with actual usage. Here’s how to implement a prorated billing model seamlessly into your small business:
- Review Your Services: Identify which of your services or products are suitable for prorated billing.
- Set Clear Pricing: You’ll need to decide on the base rate for the service and how you’ll calculate charges based on actual usage.
- Billing Period: For many businesses, this could be monthly, but it might vary depending on your industry or the nature of the service.
- Choose a Suitable Provider: Select a reputable credit card processing provider that specializes in accommodating prorated billing needs.
Implementing prorated billing can be a beneficial strategy for your small business, as it promotes fairness, transparency, and customer satisfaction.
Frequently Asked Questions (FAQs) on Prorated Billing
How do prorated credits impact the final bill?
Prorated credits impact the final bill by reducing charges for unused services. When customers cancel or downgrade their subscriptions mid-billing cycle, they receive credits for the remaining days. These credits adjust the final bill, ensuring transparency and accuracy in billing.
In some cases, customers may even receive refunds if the credits exceed the charges for the remaining period, providing fairness and maintaining customer satisfaction. Businesses should have clear policies and communication to handle prorated credits effectively.
Can prorated billing apply to hourly rates?
Yes, prorated billing can be applied to hourly rates as equally as daily or monthly rates. It’s a flexible method that calculates charges within a particular billing period instead of charging a standard flat fee. This ensures customers pay (only) for the product or service used, and comes in handy for fields like consulting, freelancing, and coworking spaces where hourly work is prevalent.
How can businesses transition seamlessly to a prorated billing system?
Clearly communicate your billing practices to customers. Explain how prorated billing works, why it benefits them, and how it ensures fairness. Transparency can help reduce customer confusion and disputes.
Additionally, invest in robust billing systems capable of handling prorated billing calculations for different subscription models and billing cycles. Ensure your systems can generate accurate invoices and automatically adjust charges. Include prorated billing terms and conditions in your customer agreements. Make sure customers understand how billing works, including any changes that occur when they switch subscription plans or billing cycles.
Most importantly, offer excellent customer support to address any billing inquiries or disputes promptly. A responsive support team can help resolve issues and maintain customer satisfaction.