An essential part of any business involves keeping track of its overall cash flow to ensure strong financial health. While many industries have a relatively straightforward way of earning revenue by receiving a one-off payment from customers, it’s a little more complicated for some industries. Subscription-based companies (which are often software as a service, or SaaS companies) earn income differently.
Let’s say you own a vintage clothing shop. If a customer came in and bought a leather jacket, they would pay the total amount upfront and instantly receive the product in full—that would be that.
On the other hand, a social media analytics SaaS platform might receive recurring payments from customers for perhaps $250 per billing cycle (generally 30 days). What makes companies offering SaaS products different from a vintage clothing store is that the former are charging their customers in advance for a service that hasn’t yet been fully delivered. With subscription billing, customers pay for a monthly service and receive the full benefit of the service over the course of a month.
The intrinsically different nature of earning and recognizing revenue for SaaS companies makes it essential to adapt the billing approach. That way, it’s possible to ensure fair practice for customers and proper revenue recognition for subscription-based companies. This article will explain prorated billing, why it’s essential, and how to start implementing prorated charges quickly.
TL;DR
- Prorated charges ensure that customers are billed only for the number of days that they actually used the service.
- Proration is primarily popular for subscription-based companies, as they rely on yearly or monthly recurring revenue and allow customers to change their subscriptions during their billing period.
- If you need to do this for hundreds or thousands of customers monthly, ensuring you’ve accurately charged your customers can take up significant time and staffing, which is why it’s common for companies to use revenue recognition software instead of manually doing the work.
What is Prorated Billing?
Prorated billing is a form of billing or invoicing customers based on the proportion of the monthly service that’s used. In other words, prorated charges ensure that customers are billed only for the number of days that they actually used the service.
Who Needs Prorated Billing?
Proration is primarily popular for subscription-based companies, as they rely on yearly or monthly recurring revenue and allow customers to change their subscriptions during their billing period.
Because of that, these types of businesses need to ensure their clients only pay for what they actually use while also protecting their revenue stream by ensuring subscribers never receive more or less than what’s included in the monthly plan they’re paying for.
Plus, if you’re a public or privately held business, it’s required that you’re compliant with ASC 606, which is a revenue recognition standard in line with the generally accepted accounting principles (GAAP). This means all subscription-based companies need to adhere to ASC 606 and use prorated billing to be fully compliant with recognizing income as revenue.
When Do You Need Prorated Billing?
For subscription businesses, any customer-initiated change to their subscription plan triggers the need for a prorated charge.
For example, customers may want to upgrade or downgrade to a new plan or even cancel or start a subscription in the middle of a billing cycle. Without applying a prorated amount to the customer’s bill, the customer would either end up paying too much for their services or receiving a higher tier of services for less.
Let’s go back to the social media analytics SaaS example from earlier. If a customer were to end their subscription mid-month, they would have to pay for an entire month and thus be overcharged by 16 days.
Conversely, if you received a new sign-up on the 14th of the month, and your next billing date is on the 1st of the next month, you would be undercharging them if they didn’t pay for the 16 days they used your analytics product for the remainder of the current billing period.
Simply offering a full refund or charging the subscriber the full amount isn’t an adequate solution, as either the customer or the business will be overcharged for a portion of the month at some point. To ensure a fair and equitable solution for all parties involved, it’s best practice to bill your customers pro rata.
How Does Prorated Billing Work?
Now that we’ve covered what exactly pro-rata billing is and when you might need it, you might wonder how it works in practice. Let’s break it down with the social media analytics SaaS example.
Imagine a customer on a lower-tier plan supporting two social media networks and three users for $200. They might decide to switch their subscription as their company scales and upgrade to a higher plan for $400 that offers support for four networks and six users on the 15th of June.
Let’s say you bill your clients at the start of the month, on the 1st. This would mean that they would be on two different plans for 15 days each and that the bill would need to be adjusted pro rata.
First, determine how much money you’re owed for the number of days on the lower-tier plan. In this case, it’d be $200/30, or $6.66 per day. This works out to almost exactly $100 for the first 15 days.
You’d also need to do the same for the higher-tier plan to determine how much to charge. In other words, ($400/30)*15 would equal roughly $200, or $13.33 daily.
This means that the client would owe you roughly $300 for the whole month. If you subtract the two amounts, you will get the prorated amount of $100, which you would charge to the client’s account for the next billing cycle, on top of the new monthly price of $400.
Implementing Prorated Charges
Prorated billing can be a tricky beast to manage. In the above example, we rounded our numbers slightly for ease of comprehension, but the actual calculations are more complicated. Plus, in real life, clients won’t often make changes to their subscription at precisely 15 days in a 30-day month, and you’ll probably have more complex pricing. All of these factors make successfully executing proration complex.
If you need to do this for hundreds or thousands of customers every month, ensuring that you’ve accurately charged your customers can take up significant time and staffing. However, it’s essential to do so to ensure customers are charged reasonably, so your business continues to grow.
That’s why it’s common for companies to use revenue recognition software instead of manually doing the work, like with Stax Bill.
Stax Bill is our all-in-one subscription management solution, and it’s the only platform available that’s 100% compliant with ASC 606 without needing additional software.
Its dual-entry accounting system fully automates revenue recognition, ensuring accurate invoicing and subscription data. Our system allows you to eliminate the risk of human error with recurring billing automation so that your business can focus on sustainable and scalable growth. We also offer a customizable self-service portal, so your customers can register and manage their subscriptions.
And with scalable data models that can handle the most complex of contracts, combined with ERP solutions integration, businesses can use Stax Bill as their single source of truth when it comes to prorated billing and revenue recognition.
Wrapping Up
Subscription-based companies like SaaS companies tend to have less straightforward ways of collecting and recognizing income and revenue than other businesses. Prorated billing ensures that all parties are fairly treated and never pay too much or too little for the agreed services, no matter when in the billing cycle the changes were made.
To ensure full compliance with ASC 606 and to keep your customers happy, subscription-based organizations must implement prorated charges for any changes to the subscription plan. Companies can save significant staffing and time by using a payment platform like Stax while reducing the likelihood of error when collecting recurring payments—it’s that simple.
Stax Bill is the only fully ASC 606 compliant subscription and billing platform available, allowing businesses to deliver a powerful subscription experience while using prorated billing seamlessly. With state-of-the-art API integrations and the latest security standards, Stax Bill is the leading source for accurate billing data—all at transparent pricing.
FAQs about Prorated Billing
Q: What is Prorated Billing?
Prorated billing is an invoicing method that charges customers based on the proportion of the service they have utilized in a billing period. This system ensures that customers are billed only for the number of days they used the service, not the entire month.
Q: Why is Prorated Billing essential for subscription-based companies?
Prorated billing is popular among subscription-based companies since they rely on recurring revenue. The nature of their services allows customers to switch their subscriptions during a billing period, necessitating a system that ensures customers only pay for what they use. Imposing prorated charges safeguards the revenue stream and ensures clients receive what’s included in their monthly subscriptions.
Q: How does a Prorated Billing system work?
The system calculates costs based on the number of days a service is used in a billing period. If a customer changes their service plan mid-month, the bill needs to be adjusted proportionately for each plan. For instance, if a user shifts from a plan costing $200 for a month to a $400 one on the 15th day, they will be charged based on the costs per day for each plan, not the total monthly charges.
Q: When should companies use Prorated Billing?
Any customer-initiated change to a subscription plan necessitates prorated billing. This could be an upgrade, downgrade, cancellation, or initiation of a plan in the middle of a billing period. Applying a prorated amount ensures the customer doesn’t overpay for services or receive additional services without appropriate payment.
Q: Are there tools to help implement Prorated Billing?
Implementing prorated billing can be complex. To save time and ensure accuracy, many companies use revenue recognition software like Stax Bill. This platform fully automates revenue recognition, provides accurate billing data, and seamlessly integrates prorated billing, making it an ideal solution for managing recurring payments.
Q: What are the benefits of prorating charges?
Prorating charges ensures fair billing for customers and protects the revenue of the company. It also helps subscription-based businesses to comply with the ASC 606 accounting principles. Further, it promotes client satisfaction by ensuring they only pay for the services they use.
Q: Is Prorated Billing a requirement for subscription-based companies?
Yes, adhering to ASC 606, which aligns with the generally accepted accounting principles, all subscription-based companies must implement prorated billing for proper income recognition as revenue. Implementing prorated charges ensures compliance with these principles.
Q: Can prorated billing be applied manually?
While prorated billing can be performed manually, it demands significant time and effort, especially for companies with large client bases making frequent changes to their subscriptions. Thus, it’s common for firms to leverage automated software solutions.
Q: How does ASC 606 relate to Prorated Billing?
ASC 606 is a revenue recognition standard in line with the generally accepted accounting principles. Its compliance requires subscription-based firms to apply prorated billing to ensure proper recognition of income.
Q: How does the Stax Bill aid in Prorated Billing?
Stax Bill is an all-in-one subscription management solution that helps implement prorated charges. It’s 100% compliant with ASC 606, automates revenue recognition, eliminates human error risks with automation, and supports businesses with scalable data models that can handle complex contracts. This helps businesses focus on sustainable and scalable growth while ensuring accurate billing data.
