Pro rata is a Latin phrase meaning ‘in proportion’. Today, the term is used to denote money or other value-based benefits paid in proportion to services rendered, based on factors like time.
The concept is prevalent in our real world dealings with payments too. For instance, this much-quoted article by Nick Hanauer & David Rolf has an excellent example of employee benefits proration designed for the sharing economy (see under the heading ‘A Twenty-First-Century Social Contract’).
Closer to billing home base, this Slate article walks you through a cheeky, step-by-step process of how to get a prorated discount on a New York Times print subscription.
Now imagine you’re setting up prorated charges for your own SaaS customers. What does it involve?
Proration Isn’t Rocket Science, Just Smart Billing
Proration can be boiled down to a simple use case:
"If a group of customers use Plan A for 20 days and switch to Plan B for the next 10 days*, they should be charged Plan A prices for two-thirds of the month and Plan B prices for the other one-third."
As you can see, it’s a way to ensure that they are charged accurately for the portion of the services they’ve used, taking into account their actions (upgrades /downgrades) to change the quantity/subscription terms of these services before a billing cycle ends.
Now consider two simple sub-use cases:
If the price of Plan A < Plan B (Plan Change Upgrade)
If Plan A is cheaper than Plan B, then according to our use case the customers are upgrading to a more expensive plan. In this case, they will need to pay an additional amount equivalent to the price difference between the plans for 10 days.
If the price of Plan A > Plan B (Plan Change Downgrade)
If Plan A is more expensive than Plan B, then they’re downgrading to a cheaper plan. In this case, the company owes them the price difference between the plans for 10 days.
This process is explained clearly with supporting examples here. And Chargebee takes one more important factor into account when it prorates charges: the state of the invoice (paid or unpaid). The more factors that go into your logic, the more complex proration gets. But good proration intelligence provides options for as many relevant factors as possible.
Let’s skirt that rabbit hole for now and get our priorities straight. Do you even need proration in the first place?
*Assuming that a billing cycle lasts 30 days
Is Proration Necessary?
If you’re just starting out, it may seem like too much effort to set up proration. Why not just remove the option to switch plans mid-cycle and set up non-prorated billing? Several businesses do choose to go with this. But while it seems deceptively simple and hassle-free in the beginning, you’ll quickly realize that it’s ill-equipped to deal with some basic challenges like:
Fair Usage-Based Charges
Without proration, you have to charge more than a customer consumes if they want to downgrade or keep them stuck on an old plan if they want to upgrade, until the next billing cycle. In the first case, the customer will feel like they’re being overcharged unfairly without options for a refund and in the second, you’re losing out on revenue. Neither is good for you or your customers..
To sum it up, proration is the smartest way to balance clean & clear bookkeeping on your end and provide convenient billing options on the customer end. And while you can leave it out of the mix if you want, you’re really going to miss it when your customer base grows.
How can you refund customers who are downgrading their plans mid-cycle?
You can simply refund the outstanding amount in the next invoice. But this doesn’t let you calculate the reduction in your tax liability or document the downgrade for reference. And what do you do when the invoice hasn’t been paid yet? You can’t return money you never received.
Instead, efficient billing systems use something akin to credit notes (you may be familiar with the term if you’ve used accounting software). A credit note is an invoice-like document which either assigns refundable credits for the equivalent of the money owed to the customer or directly adjusts the invoice amount to reflect the downgrade. It’s neat, unambiguous and effective.
The Billing Intelligencer
Explore the different facets of billing proration through a perspective-widening selection of intriguing Q&As and articles:
A great read on SaaS’s romance with the recurring billing model. Andrew Marder writing for the Capterra blog believes that "how you bill, when you bill, and what you bill " all affect your customer retention and consequently, your bottomline. Also, with different revenue scenarios to work through, he talks about the need to prorate plans in very different ways to retain customers.
Everything you need to know about SaaS billing
Is there an accounting or revenue-related reason to prorate the first month and start all SaaS customer billing cycles on a specific date? An interesting Quora question with some equally interesting answers.
The pros & cons of SaaS subscriptions that renew on subscription date vs. the first of the month
KPS from Chargebee on a dose of proration intelligence. Read about our new design overhaul to make this essential feature less fuzzy and more customer-friendly.
Proration - a dose of intelligence
If you’re looking for real-world snags with proration, here’s a Hacker News thread where business owners debate the necessity of prorated refunds. The question of whether proration is too complicated for companies to incorporate or too confusing for a customer is a valid concern. But that’s where a good billing system can level the bumps for both.
Ask HN: Monthly Billing Best Practices
Wish your prorated subscriptions were simpler to manage? Chargebee’s got it covered.