What is proration, and how does it work for SaaS billing?

What is proration?

Proration adjusts an amount proportionally based on actual usage or time within a period. It originated in utility billing and accounting for fair allocation. Proration applies to recurring subscriptions and variable usage. 

For subscriptions, it ensures billing aligns with the time a service is used, especially with mid-cycle changes. For variable charges, it bills for exact consumption. This ensures fair and accurate billing.

Why proration applies to recurring or variable charges

Proration is key for recurring and variable charges:

• Recurring charges: Customers may not start/end subscriptions at billing cycle beginnings/ends. Mid-cycle changes (upgrades, downgrades, cancellations) require proration. This approach charges/credits for the service portion used at each tier, preventing overpayment.
• Variable charges: Usage-based pricing bills for resource consumption (e.g., data). Proration ensures customers pay only for what they use within a billing period, regardless of start time or usage fluctuations.

What does proration mean for SaaS enterprises?

For SaaS with monthly/annual subscriptions, proration charges customers for the precise service portion used, especially with mid-cycle changes. It guarantees fair billing. Key aspects for SaaS companies include:

• Mid-billing cycle plan changes: Upgrades/downgrades mid-cycle trigger proration. Charges for the old and new plans are calculated for their respective usage periods. Customers avoid paying full price for partially used plans.
• Billing for actual usage: Proration bills customers accurately for the time a plan was active or resources consumed. This approach builds trust through fair billing.
• Full cycle vs. prorated charges:
  
  • Full cycle charges: Standard charges for using a service for the entire billing period without changes (e.g., $50 monthly fee).
  • Prorated charges: Adjusted charges for partial billing cycle use. Canceling a $50 monthly plan after 15 days results in a $25 charge. Mid-cycle upgrades/downgrades have prorated charges for each plan.

Note: The concept of proration is key for SaaS firms using various pricing strategies. For SaaS models with tiered pricing, proration handles mid-cycle changes between tiers. In SaaS usage-based pricing, proration is fundamental to billing customers accurately for their use. 

Even with dynamic pricing models, where prices can fluctuate, proration might be applied if a customer's usage or subscription period doesn't align with the standard billing intervals.

Common scenarios where proration happens

Proration commonly occurs in several situations within SaaS billing to confirm fair charges when changes happen mid-billing cycle. Let’s look at some common scenarios that require adjusting the billing amount to reflect the actual service used.

Plan upgrades/downgrades mid-period

Users may change their subscription tier during a billing cycle. When a customer upgrades, they gain access to more features or higher limits, usually at a higher price. Proration calculates the cost of the old plan for the portion of the cycle used and the new plan for the remaining part.

Downgrading reduces features or limits, often at a lower price. Proration credits the unused portion of the higher-priced plan and charges for the new, lower-priced plan for the rest of the billing period.  

Seat-based pricing increases

Some SaaS services charge per user or "seat." If a customer adds more users in the middle of a billing cycle, proration ensures they are only charged for the additional seats for the remaining portion of that cycle. 

For example, if a plan costs $10 per seat per month and a customer adds a seat halfway through, they would be charged $5 for that additional seat in the current month.  

Usage-based thresholds crossed

SaaS offerings with usage-based pricing often have tiers or thresholds. If a customer's usage exceeds a certain threshold mid-billing cycle, they might move to a higher pricing tier. 

Proration calculates the cost at the lower tier for the usage before crossing the threshold and at the higher tier for the usage afterward within the same billing period. You can make sure they pay the correct amount based on their actual consumption at different price points.  

Trial-to-paid transitions

When a customer transitions from a free trial to a paid subscription in the middle of a billing cycle, SaaS providers generally handle billing in one of two ways. Some reset the billing cycle to start on the transition date, in which case the customer is charged a full billing period starting from that day, and proration isn’t needed. 

Others maintain the original billing cycle and simply charge a prorated amount for the remainder of the current cycle. The approach depends on the provider’s policy.

How is the proration factor calculated?

The proration factor is the fraction representing the portion of the billing cycle for which a customer should be charged. The basic proration formula uses the number of days of service used divided by the total number of days in the billing period.

For example, if a customer uses a service for 15 days in a 30-day month, the proration factor is 30 / 15 ​= 0.5. This factor is then multiplied by the total cost of the subscription to determine the prorated charge.  

While the daily calculation is common, some systems might use hourly or even metered units depending on the granularity of the service and billing model.

Note: Edge cases can complicate proration. Leap years affect the total number of days in February for annual subscriptions. Mid-month sign-ups or cancellations require precise calculation of the days used in that partial month. 

Partial usage within a day might also need consideration for services billed hourly or by the minute. Billing systems need to account for these variations to ensure accurate proration in all scenarios

Examples of prorated billing in action

While it’s fundamental to know what proration is, examples are key to understanding how it works. This table shows some examples of calculating prorated bills:

How to sidestep proration pain points

Here are common pain points and solutions, including how a flexible billing engine like Orb addresses them.

Pain point: Manual adjustments that don’t scale

Solution: Automate proration calculations using a robust billing system. Relying on manual spreadsheets or custom scripts becomes error-prone and time-consuming as your user base and pricing complexity grow. 

A dedicated billing platform handles these calculations automatically for various scenarios like upgrades, downgrades, and mid-cycle changes, providing accuracy and saving considerable operational effort.

Pain point: Hard-coded logic across product and finance

Solution: Centralize proration logic within a dedicated billing engine. Embedding proration rules directly into your product or finance systems creates silos and makes it difficult to update or modify billing policies consistently. 

A billing platform acts as a single source of truth for all pricing and proration rules, allowing for easier management and updates without requiring code changes across multiple systems.

Pain point: Billing discrepancies mean a poor customer experience

Solution: Provide transparent and accurate proration with clear invoicing. When customers are confused about prorated charges or believe they've been billed incorrectly, it leads to frustration and potential churn. 

A solid billing system that clearly itemizes prorated amounts, explains the calculation, and integrates with customer communication channels helps build trust and provides a positive experience.

Can Orb handle proration automatically?

Yes, Orb is designed to handle proration automatically, helping SaaS and GenAI companies to achieve fair and accurate billing without the complexities of manual calculations or rigid systems. 

Orb is a done-for-you billing platform that enables you to take control of your revenue strategies by unlocking the power of your usage data.

Unlike traditional billing vendors that can be costly to change and prone to errors, Orb provides the agility and accuracy needed to manage even the most complex proration scenarios seamlessly. 

Orb RevGraph decouples usage data from pricing metrics, allowing you to easily experiment with pricing, fine-tune your monetization strategy, and drive growth without billing inaccuracies or revenue loss. Here’s how Orb simplifies proration:

• Precise proration based on usage: Orb’s raw event architecture ingests raw event data and does not drop events, no matter the scale or complexity of the incoming data. This ensures precise calculation of prorated amounts, eliminates manual errors, and guarantees your customers are billed fairly for the exact services they consume.
• Effortless handling of plan changes: With Orb’s plan versioning, managing new, current, and legacy pricing plans is simple. The platform automatically calculates prorated charges when customers upgrade or downgrade their subscriptions mid-cycle, ensuring a smooth transition and accurate billing.
• Risk-free pricing strategy testing with Orb Simulations: Orb goes beyond just billing with features like Orb Simulations. Orb uses your historical data to help you test and refine different pricing models before making any pricing changes live.
• Unified data for accurate financial reporting: Orb integrates seamlessly with your data warehouses and accounting software, providing a simplified and consistent billing operation. It helps with data accuracy across your financial stack, reducing discrepancies in prorated charge calculations and improving reporting.
• Flexible pricing and billing: Orb’s intuitive interface and SQL Editor give you the power to define your own pricing metrics and tailor your pricing models to your specific needs. Such flexibility extends to how proration is applied, allowing you to align it precisely with your business logic.

Ready to experience automated and accurate proration? Explore our flexible pricing options to find the plan that best suits your business needs. 

Unlock the full potential of your usage data with Orb's billing platform.