Definition of Proration
The word proration comes from the Latin “pro rata”, which could also be translated as “rationing”. Proration has a special application in the subscription business. For example, when payments, revenues or interest are calculated proportionally to a due date; which is very often the case with subscriptions, as customers cancel their subscriptions during a billing period, for example, or upgrade and downgrade and then benefit from the application of proration. This allows for fair billing for both the customer and the company.
Simplified example of a calculation
A good example of the use of Proration is the monthly payment of a subscription to an online communication tool. For better understanding, here is an assumption:
A person pays an amount of 90 € at the beginning of the month and can use this value the product for 30 days. If the contract is based on a pro rata fee (= pro rata), if the customer cancels before the end of the month (let’s say on the 15th), they will only owe the monthly fee for 15 days, resulting in a bill of €45. If the company did not offer this, the canceler would have to pay the full amount and would be entitled to use the service until the end of the month – even if he effectively stopped using it. In this case, the terms of the cancellation policy should be clearly stated in the contract at the time of subscription.
To calculate this, we use the simple rule of three.
Amount of the monthly fee = 90 euros
Billing period = 30 days
Actual period used = 10 days
Amount to be paid = X (unknown)
This results in the following calculation
90 euros = 30 days
X = 10 days
10 x 90 / 30 = X
X = 30 euros
Thus, the value with applied proration and a use of 10 days is 30 euros.
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When is Proration particularly useful in the subscription business?
In addition to the subscription cancellation situations explained above, the use of proration in subscription plans is very common in two other situations: during plan upgrade and during downgrade.
Upgrade and downgrade: It may happen that a customer switches within the same company to a plan that better suits his requirements. Therefore, when switching to a higher (upgrade) or lower (downgrade) plan, the timing of the switch should also be considered in terms of pro-rated billing. This monthly charge should calculate the prorated value of days due under the previous plan, which is added to the prorated value of the new plan, averaging between them.
In this context, it is necessary to monitor billing of subscription offers for each customer in a specific way – taking into account the different variables. Manually calculating monthly progress charges or interest for delinquent payers is not a solution in the subscription business. Therefore, an intelligent billing system is extremely important for enterprise billing. Today, there are subscription management solutions that enable automation of all these billing processes.
Conclusion: Proration as a smart billing solution in the subscription business
Since most SaaS products and many other subscription products or services allow changes to be made to their subscription plan in the middle of a billing cycle, it is important that the customer has the ability to adjust charges based on usage. This way, customers can be sure they only paid for the service they used. This is a great way to increase customer retention, build loyalty and encourage customers to sign up again in the future (Renewal Rate). Customer Success plays an immensely large role in the success or failure of any subscription business, so the use of Proration can have a critical impact on the success of a subscription business.