Pro Rata is the Latin word for “in proportion”. It is used to describe a method of allocating or distributing items in proportion to the relative size of each item.
In accounting and finance, Pro Rata calculations are used to calculate the portion of an expense that each party should pay.
Dividends would be a good example of this; the shareholders of a company are entitled to receive a portion of the dividends based on how many shares they own.
The total amount of dividend payments is divided between the shareholders in proportion to their ownership stake.
Definition of Pro Rata
Pro Rata is an accounting term used to refer to the process of allocating payments or costs in proportion to participants’ relative sizes. A pro rata share is calculated by dividing a payment or cost among several parties according to their relative sizes.
In simple words, it is the practice of dividing something in proportion to a person’s or entity’s share of the total. It is an equitable distribution that ensures everyone receives their fair share and doesn’t leave any party at an unfair advantage or disadvantage.
Businesses need to practice pro rata, as it ensures that all parties are treated fairly and equitably. This will help to promote goodwill between the parties, which can be beneficial when negotiating future agreements.
How to use Pro Rata
Pro Rata can be used in a variety of scenarios, including allocating payments, stock dividends, and expenses.
A Pro Rata payment is a specific type of calculation that can be used in different situations. Even though the specifics may be unique, the calculation process for a Pro Rata is always essentially the same.
Here is the formula of Pro Rata
Assets to be distributed / Items owned or costs incurred
Examples of Pro Rata
Let’s look at an example of stock dividends. Let’s company A sold 600 shares this year. And a person bought one-third of the total or 200 shares. Company A decided to offer $3000 in stock dividends.
So according to the Pro Rata calculation
Assets to be distributed / Items owned or costs incurred
$3000 / 600 shares = $5 per share
The person who bought 200 shares would receive a dividend of $1000, which is calculated as follows
200 shares x $5 = $1000
In this example, the Pro Rata calculation ensured that the investor received their fair share of the dividends based on their investment.
Pro Rata can also be used to equitably allocate expenses among several parties based on their relative sizes.
Let’s take a look at another example
Most employers calculate the Pro Rata of their hourly rate by looking at how many hours they work and their yearly income.
For example, let’s say an employee pays the same amount of hourly rate to both part-time and full-time employees, let’s say $20 an hour.
The full-time employee works 40 hours per week for 50 weeks a year, which totals 2000 hours.
A part-time employee, on the other hand, works 20 hours a week for only 50 weeks in a year, totaling 1000 hours.
So if the full-time employee makes a salary of $40,000 and the part-time employee makes $20,000.
The Pro Rata calculation will be as follows
Full-time Employee: $40,000 / 2000 hours = $20 per hour
Part-time Employee: $20,000 / 1000 hours = $20 per hour
Therefore, both employees are receiving the same hourly rate.
Conclusion
For business finance and investments, Pro Rata is a powerful tool that ensures an equitable distribution of assets and costs between parties. It ensures fairness among the participants by allocating resources according to their relative sizes. By understanding and using Pro Rata calculations, businesses can ensure they are treating everyone involved fairly and equitably.
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