How to Implement Prorated Billing: A Step-by-Step Guide for Subscription Businesses

In the world of subscription-based companies, accurate billing is crucial for maintaining a healthy cash flow and keeping customers satisfied.

One key aspect of this is implementing prorated billing, which ensures customers only pay for the portion of the service they actually use.

This guide will walk you through everything you need to know about how to implement prorated billing effectively.

What is Prorated Billing and Why Does It Matter?

Prorated billing is an invoicing method that charges customers based on the proportion of the billing period they utilized the service. Instead of a flat monthly fee, the charges are calculated based on the number of days the customer had an active subscription.

For subscription businesses, prorated billing is essential because it:

1. Prevents Overcharging or Undercharging: Without proration, customers would overpay if they downgraded or canceled mid-cycle, or underpay if they upgraded or signed up partway through.
2. Ensures Fair Billing: Customers only pay for what they actually use, increasing transparency and satisfaction.
3. Protects Revenue Streams: Companies receive the appropriate payment for services rendered, safeguarding income.
4. Maintains Compliance: Many accounting standards, like ASC 606, require prorated billing for proper revenue recognition.

For example, let’s say a customer is on a $50/month plan and decides to cancel on the 15th day of the billing cycle. With prorated billing, they would only be charged $25 for the 15 days of service instead of the full $50.

When to Apply Prorated Charges

Subscription businesses should apply prorated billing whenever a customer initiates a change to their plan mid-billing cycle. This includes:

Upgrades: If a customer upgrades to a higher tier, they must be charged the prorated amount for the remaining days based on the new plan’s pricing.

Downgrades: Similarly, if a customer downgrades, they should only pay the prorated cost of the new lower-tier plan for the remaining cycle.

Cancellations: When canceling, customers should receive a prorated final charge for the days they had an active subscription.

New Signups: New customers need to be prorated for the partial first billing cycle until the regular billing date.

Not prorating charges in these scenarios leads to the customer paying too much, receiving more than they paid for, or the company losing revenue – an inequitable situation for all parties.

Prorated Billing and ASC 606 Compliance

For subscription companies, prorated billing is not just a best practice but often a requirement for compliance with accounting standards like ASC 606 (Accounting Standards Codification 606).

ASC 606 provides guidance on how businesses must recognize revenue from customer contracts. It stipulates that revenue can only be recognized once the performance obligations related to those earnings have been satisfied.

For subscription businesses, this means revenue must be recognized over the billing period as the service is delivered, not upfront when payment is received. Prorated billing is the mechanism that ensures companies comply by only recognizing revenue for the portion of service rendered each period.

Public companies are legally required to follow ASC 606, while private companies are expected to as well in order to uphold Generally Accepted Accounting Principles (GAAP). Non-compliance can lead to inaccurate financial reporting and legal issues.

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How Prorated Billing Works?

At its core, prorated billing calculations involve:

1. Determining Daily Rates for each plan or pricing tier.
2. Calculating Charges based on those daily rates and the number of days per plan.

Let’s illustrate this with an example:

Example: A customer is currently on the Basic $20/month plan and upgrades to the Premium $50/month plan on the 15th day of the billing cycle.

Basic Plan Daily Rate: $20 / 30 days = $0.67/day

Premium Plan Daily Rate: $50 / 30 days = $1.67/day

Charges for the Cycle: – Basic: $0.67 x 15 days = $10.05 – Premium: $1.67 x 15 days = $25.05 – Total for Billing Cycle: $10.05 + $25.05 = $35.10

So the customer would be charged the prorated amount of $35.10 total for that billing period to account for 15 days on each plan respectively.

When the next billing cycle begins, they would start being charged the standard $50 Premium plan rate unless they make another change.

Handling Complex Proration Scenarios

While the core calculation is straightforward, prorated billing can quickly become complex when factoring in variables like:

• Varying Billing Periods: Most examples use a 30-day month, but proration must account for 28, 29, 31 days.
• Multiple Mid-Cycle Changes: If a customer upgrades and downgrades in the same billing period, all plan changes require proration.
• Custom Pricing: For custom pricing tailored to each customer, daily rates need to be uniquely calculated.
• Taxation and Proration: Taxes and fees must be accurately prorated based on jurisdictions and plan types.

Subscription businesses with elaborate pricing models and a high volume of changes are likely to require robust billing software to handle these intricate proration scenarios efficiently.

Implementing Prorated Billing

Companies have two main routes for implementing prorated billing: manual processes or automated software solutions.

Manual Proration involves calculating prorated amounts for each change using tools like spreadsheets. This option can work for businesses with lower complexity and scale, but has drawbacks:

• Time and Labor Intensive: Manually adjusting every invoice is tedious and requires dedicated staffing.
• Error-Prone: Even a simple mistake can lead to incorrect invoicing for multiple customers.

As a result, many companies opt to utilize revenue recognition software purpose-built for prorated billing and subscription management, which offers:

• Automation: Prorated charges are accurately calculated without manual effort.
• Scalability: Can efficiently handle any number of customer changes and pricing complexities.
• Unified Data and Reporting: All subscription and invoicing data is centralized for easy analysis.

By automating prorated billing, companies can ensure accurate revenue recognition, reduce overhead, and focus on growth rather than tedious calculations.

Introducing Stax Bill

One leading solution for subscription billing and prorated charges is Stax Bill. As an all-in-one subscription management platform, it provides:

• Full ASC 606 Compliance: Stax Bill is the only software guaranteed 100% compliant without needing additional tools.
• Automated Revenue Recognition: Its dual-entry accounting system automates proration and recognizes revenue accurately.
• Customizable Usage and Billing Models: Supports even the most complex pricing structures and business models.
• Self-Service Subscription Management: Customers can view and modify their subscriptions through a customizable portal.
• ERP Integration: Seamlessly integrates billing data with Enterprise Resource Planning (ERP) systems.

By implementing Stax Bill, subscription companies can eliminate error-prone manual processes, maintain compliance, and deliver a premium subscriber experience – all while accurately recognizing revenue.

Getting Started with Prorated Billing

If your subscription business has been using flat monthly billing previously, getting started with prorated billing will require some preparation:

1. Evaluate Current Processes: Assess things like pricing models, existing tools/software, accounting practices, and staff roles related to billing. Note areas that need to change.
2. Select Software (if applicable): If pursuing an automated solution, thoroughly evaluate different revenue recognition platforms for features and pricing that fit your needs.
3. Implement Software and Train Staff: Roll out the new solution making sure staff is trained on proper usage. Establish clear roles and responsibilities.
4. Update Billing Processes: Whether automated or manual, document the new end-to-end processes for how proration will be handled.
5. Communicate with Customers: Make customers aware of the upcoming change to prorated billing and explain why it benefits them.
6. Launch Prorated Billing: Rollout proration on a set future billing date after preparations are complete.

The upfront effort is well worth it to reap the rewards of accurate billing long-term. Many businesses bring in outside expertise to ensure a smooth implementation.

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Conclusion

In the subscription economy, prorated billing is essential for maintaining satisfied customers, protecting revenue, and ensuring compliance. By only charging for the portion of service rendered, businesses avoid overcharging or undercharging when customer plans change mid-cycle.

While implementing prorated billing can introduce complexities, it’s a necessity for responsible subscription companies – the benefits far outweigh any challenges.

FAQ’s

What is an example of prorated billing?

If a customer upgrades from a $20/month plan to a $50/month plan on the 15th day, they would be charged $10 for the first 15 days on the $20 plan and $25 for the remaining 15 days on the $50 plan – a total prorated amount of $35 for that billing cycle.

What is a prorated billing cycle?

A prorated billing cycle is one where the customer is charged for only the portion of the billing period they actually had an active subscription, rather than a flat fee for the full cycle.

How to explain prorated charges to a customer?

Explain that prorated charges ensure they only pay for the days they actually used the service that billing period. If they upgrade, downgrade or cancel mid-cycle, proration avoids overcharging or undercharging compared to a flat monthly fee.

How to do a prorated calculation?

Calculate the daily rate by dividing the plan’s cost by the number of days in the billing period. Then multiply the daily rate by the number of days the customer had that plan to get the prorated charge.

What is a simple explanation of prorated?

Prorated billing means you only pay for the portion of a service you actually used, rather than the full period’s cost. It ensures fair charges when your subscription changes mid-billing cycle.

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