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Prorated

Step-by-Step Guide to Understanding Prorated Rent (Pro-Rata Payment Billing)

Last Updated June 19, 2024

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Prorated

What Does Prorated Mean?

The term “prorated” is derived from the Latin phrase “pro rata,” which translates to “in proportion to”.

The proration method is the process of adjusting costs, payments, or charges to reflect the actual amount of time or usage, ensuring fair and accurate billing to customers.

If the payment structure is charged on a pro-rata basis, there is an obligation to adjust the charge to reflect the time or usage rather than a fixed pricing rate for a given billing cycle.

For instance, suppose a customer’s product or service usage is partial relative to the expected usage (i.e. <100%).

In that case, the customer’s bill must reflect the correct prorated amount owed, with the adjustments applied so that the appropriate portion is charged based on the actual usage.

Prorated billing and payments are necessary to ensure transparency in financial transactions between a company (or the provider) and the customer.

By charging the right prorated amount, the company avoids the risk of overcharging (or undercharging) customers so that the invoice sent to the customer accurately reflects the real usage or period relevant to the pricing.

If a company consistently bills customers the incorrect amount—even if corrected shortly afterward (i.e., a prorated refund)—customers will lose trust, which can have negative ramifications over the long run.

Note: The service provider can deduct certain fees, as outlined in the subscription agreement. The invoice received for the billing cycle should include the specific details and adjustments made to the charge.

When is Prorated Billing Used?

There are plenty of real-life scenarios in which proration is used, such as the following:

Proration Type Description
Prorated Rent
  • If a tenant moves into or out of a rental property partway through a month, the rent owed for the month is often prorated to reflect the actual number of days the tenant occupied the property unit.
Prorated Bill (Utility)
  • Likewise, utility bills for services like HVAC, electricity, water, internet, and certain fees can be prorated based on the number of days the service was used within a billing cycle.
Prorated Employee Wages
  • If an employee were to start or leave—either on a voluntary or involuntary basis—a job in the middle of a pay period, the subsequent pay stub would be prorated to reflect only the number of days worked.
Prorated Subscription Services (Contractual)
  • The subscription-based or SaaS business model frequently uses prorated billing to adjust charges when customers sign up, upgrade, downgrade, or cancel their subscriptions partway through a billing cycle, ensuring customers are only charged for the portion of the service used.
Prorated Insurance Premium
  • Insurance companies can prorate premiums when a policy is initiated or canceled partway through the coverage period — i.e. the prorated premium would be calculated based on the days covered.
Prorated Shareholder Dividend
  • The common dividends issued per share by a company can be prorated based on the number of shares owned per shareholder, for the dividend received to be proportional to the ownership stake.
Prorated Shares
  • Certain hybrid instruments, such as convertible debt, offer the investor the option to convert their holding into an ownership stake in the common equity of the underlying issuer.
  • If the holder of the convertible bond decides to convert the debt into equity, the investor is entitled to receive a set number of prorated shares.

Prorated Charge Formula

Proration is used to determine the proportionate billing or payment that applies based on the fraction of the total period or usage.

The prorated charge formula equals the total cost multiplied by the fractional adjustment or the number of units used divided by the total number of units available in a full billing cycle.

Prorated Charge = Total Cost × (Number of Units Used ÷ Total Number of Units)

The “Total Cost” is the total bill assuming 100% usage (i.e. maximum payment for billing cycle), while the number of units used can refer to the number of days, time, items, etc.

How to Calculate Prorated Rent

The concept of charging prorated rent in the real estate industry pertains to the initial and final month of a lease.

For instance, a tenant moves into (or out of) a rental property partway through a month in most cases rather than right at the start (or end) of the month.

Therefore, the monthly charge must be adjusted to reflect that mismatch in timing.

Prorated billing ensures that the tenant only pays for the days in which the rental property was occupied.

For instance, if a tenant moves in on the 10th of June, they will be billed from the 10th to the end of the month rather than for the entire month.

On the topic of a lease renewal—where the monthly charge under the new lease is rarely the same as the prior lease—the start date usually does not coincide with the end of the month.

Hence, prorated rental billing must be applied to adjust the rent for the partial period — which is a common practice intended to ensure the tenant pays only for the actual duration of their stay during the transition period.

Prorated Rent Formula

The “Units” component of the prorated payment formula refers to the number of days that have passed since the billing period’s initial start date.

The prorated rent formula equals the total cost multiplied by the fractional adjustment, which is based on the time the subscription was active.

Prorated Rent = Total Cost × (Number of Active Days ÷ Total Number of Days in Month)

Where:

  • Total Cost ➝ Monthly Rent (100% Occupancy)
  • Number of Active Days ➝ Number of Days Occupied by Tenant
  • Total Number of Days in Month ➝ Total Number of Days in Move-In Month

If a customer is onboarded and their subscription becomes active mid-month on the 15th day, the fractional adjustment applied to the monthly charge is 50%, assuming there are 30 days in the month.

Prorated Salary Formula

For example, if an employee is paid an hourly rate of $60 per hour and is scheduled to work 20 hours per week, the bi-weekly salary is $2.4k.

  • Hourly Rate = $60.00
  • Total Hours Worked (Maximum Capacity) = 20 Hours
  • Bi-Weekly Salary = ($60 × 20 Hours) × 2 = $2,400

The formula to calculate the prorated salary is as follows:

Prorated Salary = Total Salary × (Number of Hours Worked ÷ Total Number of Hours)

Where:

  • Total Salary ➝ Gross Earnings at Maximum Hours (100% Capacity)
  • Numbers of Hours Worked ➝ Actual Number of Hours Worked
  • Total Number of Hours ➝ Maximum Capacity for Number of Hours Worked

But if we assume that the employee worked only 10 hours per week for both weeks, the prorated compensation is only $1.2k (i.e., the total hours billed are at the midpoint of the scheduled hours).

  • Actual Hours Worked (50% Capacity) = 10 Hours
  • Bi-Weekly Salary = ($60 × 10 Hours) × 2 = $1,200

Note: Confirm the timing of each metric is consistent across the entire calculation,  or else the output will be inaccurate.

How is Prorated Billing Used in the SaaS Industry?

Prorated billing is an invoicing method used to ensure that customers are charged fairly in accordance with their respective usage of a particular product or service within a given billing period.

Unique to the SaaS industry, the standard B2B business model is oriented around generating recurring revenue from customers, which entails receiving payments for products not yet delivered.

Therefore, deferred revenue is recorded on the balance sheet of SaaS businesses, which measures the total customer payments collected but is not recognized on the income statement (i.e. unearned revenue).

Common real-life scenarios in which prorated billing is applied include the following examples:

  • New Subscription Sign-ups ➝ If a customer signs up for a subscription in the middle of a billing cycle, such as a couple of weeks into the month, prorated billing is applied to charge the customer for only the remaining days until the end of the billing cycle.
  • Subscription Tier Upgrades or Downgrades ➝ If a customer decides to upgrade or downgrade their subscription plan to a different tier in the middle of a billing cycle, prorated billing can be applied to determine the appropriate charge for the current period.
  • Subscription Cancellations (Churn) ➝ If a customer cancels their subscription plan—referred to as “customer churn”—before the end of a full billing cycle, prorated billing measures the pro rata charge for the number of days where the subscription was active. However, the company must issue a refund based on the prorated billing if the customer payment was collected beforehand, such as an annual subscription plan.
  • Subscription Quantity Changes ➝ If the number of subscriptions increases (or decreases), such as an enterprise client purchasing more commercial licenses (i.e. seats), in the middle of a billing period, prorated billing is applied to calculate the total charge.

Prorated Rent Calculation Example

Suppose you’re a property owner tasked with calculating the prorated rent for a new tenant who moved in on the 6th day of a 30-day month.

Therefore, the new tenant occupied the rental unit for 24 days out of the 30 days in the first month of the rental agreement rather than the entire month.

Since our hypothetical tenant’s move-in date was the 6th of a month with 30 days, we’ll divide 6 by 30, resulting in a 20% vacancy rate.

  • Vacancy Rate (%) = 6 ÷ 30 = 20.0%

Subtracting 20% from 1, the implied fractional adjustment—the inverse of the vacancy rate—results in an occupancy rate of 80%.

  • Occupancy Rate (%) = 1 – 20.0% = 80%

In other words, the tenant will be charged 80% of the full rent for the current billing cycle.

Considering the full-month rent is $5k, the next step is to multiply the full cost by the prorated adjustment to arrive at $4k for the monthly billing.

  • Prorated Rent = $5k × 80% = $4k

After the partial month, where the tenant paid only $4k, in the subsequent months, when the tenant occupied the unit for 30 days, the tenant will be charged $5k, i.e., the full price.

However, for the partial month, the tenant will only be charged $4k on the billing date since the unit was only occupied for 24 days.

In closing, the price difference between a standard, normalized month and the partial move-in month is $1k (i.e. $5k subtracted by $4k), which reflects the amount saved by the new tenant.

  • Full Monthly Rent = $5,000
  • Prorated Rent = $4,000
  • Differential in Monthly Rental Charge = $5,000 – $4,000 = $1,000

SaaS Prorated Refund Calculation Example

A prorated refund is a partial refund offered to customers based on the amount of a product or service used.

The issuance of prorated refunds—or any form of invoice processing on a pro-rata basis—is most common for SaaS and subscription-based companies, where the business model is oriented around securing long-term contracts with B2B clients.

The refund—issued on a pro-rata basis—occurs after the customer decides to cancel (or downgrade) their subscription plan before the end of a billing period.

Therefore, the SaaS provider must ensure the B2B customer is charged only for the services received before the cancellation (or downgrade).

For instance, if a customer pays $50k in advance for a one-year subscription but cancels after six months, the customer is entitled to a prorated refund of half the annual fee (or $25k).

Hence, the payment retrieved from the customer is not recognized as revenue under accrual accounting until the product or service is delivered.

Since the customer used the service for less than a year, the company must return the prorated amount collected in proportion to the customer’s actual usage.

  • Prorated Refund = $50k ÷ 2 = $25k
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