Prorate

What Does It Mean to Prorate?

To prorate means to assess or divide something proportionately. Many in business define “prorated” as adjusting the cost of a service or product based on the portion that has actually been used.

For example, let’s say your company provides a service that costs $15 per month and a customer signs up on the 21st day of the month. You may offer that customer a prorated charge of $5 for the month because they’ll only use the service for one-third of the month.

How Does Proration Work?

Because the concept of proration is derived from the term “pro rata,” it implies that an asset will be divided and distributed in equal portions. Typically, proration works by determining how much each equal portion of time “costs” and multiplying that cost by the amount of time someone is using the asset.

Let’s say that a car insurance company charges a driver $492.90 per month in insurance premiums for a six-month policy on a truck they drive. If the insured individual cancels their policy four and a half months into the six-month policy, the insurance company would owe that customer a refund for the time the policy goes unused.

The insurance company can use the following steps to determine the prorated refund:

1. Monthly Cost x Duration of Policy = Total Premium: $492.90 x 6 = $2,957.40
2. Total Premium / Number of Days of Duration = Daily Insurance Premiums (January 1 to June 30 is typically 180 days): $2,957.40 / 180 = $16.43
3. Daily Premiums x Days Unused = Refund Amount: $16.43 x 46 = $755.78

You can also calculate proration by determining that the customer used the policy for 134 days between January 1 and May 15 and multiplying that by the daily rate of $16.43. Then, you would subtract that total from $2,957.40 to get the same prorated price.

What Is Proration Used for in Business?

Proration has many uses in the business world, from paying out for stock ownership to calculating employee wages. Here are four ways proration is useful as a tool for determining payments and allotments of other resources.

Dividends

If a company has 100 shares outstanding for which it pays $30 per share, it owes shareholders $3,000 for those shares. However, when it comes to dividends, shareholders do not receive equal payouts. Instead, companies prorate the payout to each shareholder according to the number of shares that the individual currently holds.

For example, one shareholder may have 50 shares, another 30 shares, and another 20 shares. In this case, those shareholders would be paid $1,500, $900, and $600, respectively. A total payout of $3,000 for all shares is determined, and then individual payouts are divided proportionately among the shareholders.

Monthly Payments

All types of businesses use proration to adjust monthly payments for customers who don’t use a service for an entire month. This often happens when someone leases an apartment in the middle of a month or terminates their lease before the term is up. It is also frequently used for utility and insurance premium payments when a customer signs up before a new month begins.

To calculate the prorated payment, the real estate, utility, or insurance company typically divides the monthly total by the number of days in the month to come up with a daily rate. The company will then multiply the daily rate by the number of days the customer will actually use the asset.

Employee Wages

HR professionals use proration to determine the amount of pay an employee should receive based on the actual amount of time worked. For example, an employee may earn a salary of $150,000 annually. However, if that employee starts working on May 1 instead of January 1, they will only receive two-thirds of their pay for the year.

This means that, for the first year, the employee will make $100,000. Once a new year arrives, the employee will be paid their normal yearly salary of $150,000 as long as they work the entire 12 months. Proration may also be applied to annual bonuses.

It’s important to prepare new hires for this reality, especially since their pay stubs and W-2s will reflect this lower, prorated salary.

Paid Time Off (PTO)

PTO is yet another area in which HR professionals need to use the concept of proration. For example, a company that provides 21 sick leave, vacation, or personal days per year (168 hours) may only provide 10.5 of those days (84 hours) to employees who start the job mid-year.

In some cases, you may choose to prorate PTO based on how many hours an employee works. This is referred to as the “accrual” method. For example, an employee may receive two hours of sick leave for every 30 hours worked. If the employee only works 15 hours, you might only give them one hour of sick leave.

It’s important to pay attention to the labor laws in your state when prorating vacation and sick leave time. Some states have laws that specifically state how to calculate paid leave and enforce minimums and maximums for certain businesses in the private sector.

Benefits of Proration

If you’re wondering, “What is proration’s biggest benefit?” the answer is that there are several major advantages. How a person benefits from this practice depends on which side of the business equation they’re on.

Customer Benefits

Customers benefit from proration because they’re able to pay a fair (and often lower) price for services obtained from a business.

Proration also offers customers the gift of flexibility. They can access a service whenever the need arises instead of having to wait until the beginning of the month. This is important when it comes to moving into a new home or signing up for car insurance or utilities.

Benefits for Businesses

Because prorating is a fair practice, it helps businesses build an excellent brand reputation. This, in turn, allows customer service representatives to build positive relationships with customers and more easily earn their trust and loyalty.

If competitors aren’t doing the same, proration can help businesses stand out in the market as the preferred choice.

Finally, understanding the concept of proration helps keep businesses compliant with wage and paid leave laws. This not only reduces the risk of audits and lawsuits, but it can also boost employee morale, engagement, and trust.

Best Practices When Prorating

What does it mean to prorate effectively? Doing so requires organizations and HR professionals to have clear policies, consistent methods, and excellent record-keeping skills. Otherwise, it can be tricky for both customers and employees. Here are some best practices that can help you avoid common challenges associated with this practice.

Honesty

It’s important to inform customers and employees of all policies surrounding proration.

If an employee’s pay or benefits will be prorated, tell them verbally and in writing in their employee contract and employee handbook.

Information about proration should appear in any communication you have with customers regarding payment, including the terms and conditions of their service contract and on any bills or invoices you send.

Consistency

Your proration policy needs to be applied consistently to all parties without exception. This is why it's best to stick to a written policy and formula you use for all prorated calculations.

If you’re not consistent, you may open yourself or your company up to accusations of discrimination, lawsuits, and compliance issues. It can also impact your employer brand or your reputation with customers.

Tracking

It’s important that your business has a way to track which customers or employees are receiving prorated rates, pay, or benefits. Otherwise, miscalculations can be costly, especially when it comes to issuing refunds, paying employees correctly, or estimating payroll taxes owed to the IRS.

Having a digital platform to help you track these things automatically can be helpful in avoiding issues in this area.