Prorated
The appropriate allocation or adjustment for a specific need at a specific time
What Is Prorated?
In accounting and finance, pro rata means the appropriate allocation or adjustment for a specific need at a specific time. It is a great way of allocating the exact cost to a certain item at a particular time.
For instance, have you ever tried to cut a subscription you didn't like and asked for a refund? Might have, as generally, everyone wants the best value for their money and companies try to stick to their policy by giving clauses in the contract to retain the paid subscription revenues.
“Yikes! That is one dissatisfied customer”. So, how can companies avoid this situation?
Well, for starters, how about returning the unutilized money to the customers? Well, it is easier said than done, as subscription-based models are generally fixed, and any changes are bound to affect the business model.
Then how can a company avoid dissatisfying customers while not breaking the company’s operation rhythm? There is a solution, and that is pro rata (or prorated). “But what do you mean by prorated service?” we hear you say. Well, why don’t we find out.
Key Takeaways
- Pro-rata is a theoretical concept of appropriate allocation where the pricing of commodities or services is allocated based on consumption levels.
- Prorated charging means accurately and fairly billing customers based on their actual use of services, ensuring they pay only for what they consume.
- It is crucial for subscription-based businesses, like SaaS companies, to implement proration to maintain customer satisfaction and avoid negative reviews that can harm their brand reputation.
- Proration is applicable in various scenarios, including subscription changes, employee/contractor work, utility bill settlements, and rental/tenant shifts, but not for dividends.
Understanding Prorated
Prorated is charging customers accurately and fairly according to service utilization while compensating the seller. In a nutshell, prorated means charging customers based on the consumption of the services.
It is not rocket science; it's just basic common sense. Prorated or pro rata derives from Latin origins meaning “according to the share”, which is used to determine a commodity’s proportional allocation of its value at a point in time.
In accounting and finance, prorated simply means making adjustments for a specific need during a specific period. In other words, proportional allocation. This allows companies to be flexible to the posed circumstances.
From this observation, prorated services ensure that customers will be charged for what they have consumed and not for those yet to consume, even if they stop the consumption of the commodity or service.
Proration ensures fairness and accurate charges to customers, and it is an essential element for any business to consider, especially subscription-based businesses, as they are bound to encounter customers who want to cancel their subscription amidst the billing month.
Importance of Prorate
Any form of business knows you upset the customer, and you are done for. Customer satisfaction is a prime metric every business around the world takes seriously. Any negative review, especially word of mouth, is enough to plummet years' worth of brand reputation.
Therefore, addressing the issue of charging customers for a service that a customer no longer wants to pursue is a make-or-break matter at hand. Fortunately, proration exists and presents itself as a solution to this issue.
Proration allows companies to take a long-term approach without sabotaging their operations by
- Providing services aligned with customer consumption enables businesses to charge customers without affecting business operations.
- Maintaining quality customer service and engagement while retaining the existing customer base.
- Building brand reputation and market recognition by instilling customer trust and loyalty.
- Becoming flexible and allowing provisions to meet unexpected future customer needs and requirements.
- Marketing their services based on customer satisfaction and word-of-mouth recommendations.
When is Pro Rata Used?
Proration can be utilized in circumstances where a customer has an agreement with the service provider on the consumption of the services. As mentioned before, proration provides flexibility to the customer and maintains a good relationship with the service provider.
If a customer withdraws from services in the middle of the next billing date, they will receive a prorated credit on the remaining unused services. But if the customer upgrades a service amidst the billing cycle, then the customer is charged additional fees to cover the unpaid portions.
Situations where pro-rata comes to aid is when the situation needs a sudden change or adjustment due to unfavorable and unexpected circumstances occurring in the middle of a service. Some of such common situations where pro-rata plays a significant role are:
- Subscription-based businesses (SaaS - Software as a Service)
- Employee/contractor work
- Utility bill settlement
- Rental/Tenant shifts
- Dividends
- Insurance Premiums
- Interest Rates
Note
There are many situations where prorate is not applicable, such as dividends. As shareholders invest in a company in hopes of increasing their wealth, and when the company pays out dividends, it is based on the time since the shareholder became a shareholder and not from the start of the month.
How To Implement Prorate Effectively?
Now, getting to this point sure should have given some insights on the effectiveness and importance of proration to a business. “But how to implement it?” is another question that is bound to be asked by curious minds.
In simple words, pro rata implementation depends on the type of business operation and how large the scale is. As a concept, proration is a simple solution addressing a common issue faced by every B2C (Business to Customer) business.
And businesses actually implementing pro rata policy is a whole other story to tell.
Implementing proration is heavy number crunching and revolves around complex calculations based on the enterprise level, as businesses should consider the effect that takes place due to different circumstances, such as customer cancellations on the last day of the billing date.
Invoices should, therefore, be sent only after an accurate amount has been determined. No one advocates for a potential conflict, now do they? So, let us explore some tips to ensure accurate proration.
- Monitor the revenue effect a proration has on the business operations. Revenue recognition is a major concern for SaaS businesses as proration can affect the revenue flow depending upon the consumer's decisions, leading to the mistake of recognizing the wrong amount from a subscription as revenue.
- Ensure that companies practice transparency in their business operations. Every customer or any individual who has an interest in the company deserves to know how the company operates, therefore increasing public confidence and trust.
- Leverage modern technology and advancement. Since the 90s, businesses have embraced computers and entered the digital age, attaining efficiency and accuracy. Since then, modern technology has progressed so far that efficiency and accuracy are enhanced multiple folds by artificial intelligence (AI) or even other collection service providers such as GoCardless.
How To Calculate Pro Rata
Now, calculating pro rata at first can be daunting, but understanding its logical process should enable the individual or company to figure out how to apply pro rata to their product.
The formula for pro rata distribution calculation is simple; it is as follows:
Pro rata share * Related quantity
“But what do you mean by pro rata shares and related quantity?” You might ask. Well since pro rata is a numerical tool, it requires a certain amount of variables to process, which provides an accurate outcome.
But please don’t get scared by the heavy terminology; once you understand the concept, it is as simple as daylight. As a matter of fact, you might have implemented the same technique in your life without realizing it. Below, we will provide steps to calculate pro rata:
Step 1: Identify the variables
It is important to group the essential variables that are relevant to the question raised. Using non-relevant variables will provide inaccurate results and waste useful resources in evaluation and execution. So it is better to avoid such circumstances.
Below are the required variables for pro rata calculation:
- Number of relevant items that are true, incurred, or even owned
- Maximum quantity of total items
- Number of related items
Step 2: Find pro rata share
After allocating the right figures at the right variable, it is easy to find pro rata shares as it provides insight into proper allocation per share. To find pro rata per share:
Number of Related Items / Maximum Quantity of Total Items
Step 3: Find pro rata distribution
Knowing the pro rata per share makes it easier to assess the prorated figure for the necessary situation. Let us use the pro rata per share to find the overall distribution of the related item, if any.
As mentioned before, the formula to find pro rata distribution is:
Pro rata share * Number of True (Relevant) Items
Prorated Illustration
We know from the above explanation you might be scratching your head on how to implement it. Half-baked cake never tastes amazing. So, to fully understand the concept, let us use a simple scenario to explain it.
Suppose you have a small-sized car rental business. And you are renting a car to a tourist. The tourist has taken the rental agreement for three months. The monthly rental payment the customer agreed to for a sedan-class car was $800.
During the 2nd month, the customer decided to use public transportation as it was much cheaper and more efficient in reaching destinations and avoiding traffic. Due to this, the customer approached you and requested you for a cancellation.
You agreed to the request and decided to charge eight days' worth of rent for the 2nd month. Based on this, you need to charge the customer the appropriate amount. Here, pro rata comes to aid; let us figure out how much to charge the customer.
The relevant variable that affects the rent is the number of rental days. Therefore, here, the number of true items is 8, since the 8 days of rent need to be charged.
The number of related items is a $800 monthly payment, and the maximum quantity of total items is 31 days (monthly rental days). Using this, the pro rata share is calculated as follows:
Number of Related Items / Maximum Quantity of Total Items
= $800 / 31 days
= $25.80
The $25.80 is the pro rata share, revealing the car's per-day rental cost. Now, to find the pro rata distribution to find the total rent to be charged, just multiply the pro rata share with the relevant items; here, relevant items are days rented by the customer (8 days).
Pro rata share * Number of True (Relevant) Items
= $25.80 * 8 days
= $206.4
The total rent you need to charge the customer for the 8-day rental is $206. Since you have agreed to the customer’s request for cancellation, the customer has paid the rent to which you have received $206 when you expect to receive $800 for the 2nd month.
Prorated FAQs
The prorated amount is the amount charged to customers based on the consumption levels of the provided services.
Any business or freelance individuals who engage in providing services to customers on a subscription-based approach should incorporate proration strategies into their operation plan.
Not exactly. Proration does not necessarily mean a refund or a discount, even though it may look like one. Proration works based on retaining customers by providing credit on unconsumed services, which are transferable to the next payment.
A prorated amount is the amount charged to customers based on the customer’s consumption levels. These are typically month-end charges charged to customers for the consumption of the subscribed services.
A non-prorated amount is a cyclic amount received by the beneficiary, i.e., the service provider, at the billing date, regardless of the level of consumer consumption. The service provider will charge a fixed amount and has an active no-refund policy that a customer should abide by.
Proration is a fair pricing policy that can be used everywhere, be it by an individual or a company. Now, to give an example of a proration policy, let us take an example of a familiar scenario of paying salaries to employees.
A new employee has agreed to a salary package of $6,000. The new employee's starting date is in the middle of the month. Due to this, the employee received $3,000 on the payday, which was calculated based on the time of joining till the date of receiving the paycheck.
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