Billing & Monetization

Forecasting Annual Recurring Revenue – What You Need to Know

March 19, 2021

As a subscription business the metrics needed to accurately forecast your annual recurring revenue – not to mention the dozens of acronyms associated with annual recurring revenue calculations – are many. Let’s look at the primary types of recurring revenue pricing models and the metrics needed when forecasting annual recurring revenue. Understanding when they should be used and how they affect recurring revenue is critical.

Choose the Right Recurring Revenue Model

You have choices when determining the monetization model to implement. While they all provide predictable recurring revenue, you need to choose the one that fits your industry and business model best. Essentially, there are three basic recurring revenue models:

  • Pure subscription pricing: The amount charged and revenue received is a predetermined fixed amount for the products or services provided – regardless of actual usage. A simple flat-rate cost structure, some uses include magazine subscriptions and music streaming services such as Spotify.
  • Consumption pricing: Revenue from this model is variable and determined by the amount of resources the customer uses. The usage-based (aka consumption) pricing model is used extensively by utility companies, ride-share services, cloud storage companies, etc.
  • Hybrid pricing: One of the most complex pricing models, it provides the ability to create virtually any combination of one-time charges. The hybrid subscription model enables companies to bill for both fixed and variable use, and is used by a variety of industries such as cell phone carriers and meal kit delivery companies.

While there isn’t a magic formula to determine which pricing model you should incorporate, remember each comes with its own challenges and benefits.

Key Metrics to Forecasting Annual Recurring Revenue

A lot is available about annual recurring revenue and monthly recurring revenue. But let’s talk definitions and calculations of other metrics needed when accurately forecasting annual recurring revenue.

  • Annual recurring revenue (ARR) is the normalized revenue that you can expect to receive on an annual basis. ARR takes into consideration revenue lost from customer churn and downgrades, as well as additional revenue received from new customers, add-ons or upgrades. It does not, however, include one time charges, such as professional services and training. As a simple example, let’s assume you have 100 customers that each purchased a 2-year subscription at $15,000. In that case your ARR would be $750,000 (100 x $15,000 / 2 = $750,000).
  • Monthly recurring revenue (MRR) is the amount of predictable revenue that you can count on receiving on a monthly basis. MRR considers revenue lost from customer churn and downgrades, as well as additional revenue received from new customers, add-ons or upgrades. For example, if you have 100 subscribers each paying $200 per month, your MRR is $20,000 (100 x $200 = $20,000).
  • Customer lifetime value (CLV) is the total revenue you can reasonably expect to receive from a single customer over their lifetime with your organization. Determining CLV involves calculating the average purchase value, average purchase frequency rate, and average customer lifespan. Using one of the simplest formulas for measuring CLV, we’ll assume that an average order is $500, the average number of purchases made in a single year is 2, and your average customer retention rate is 5 years. That would mean your CLV is $5,000 ($500 x 2 = $1,000 x 5 = $5,000).
  • Customer acquisition costs (CAC) are the costs to acquire new customers. This includes advertising and marketing costs, the salary of your marketers, sales representatives’ compensation, and more. Related to customer lifetime value, you want your CAC to be substantially less than your CLV. For instance, let’s say that during a certain time period you spent $20,000 to acquire new customers and during the same timeframe you gained 25 new customers, your CAC would be $800 per customer ($20,000 / 25 = $800).
  • Customer churn rate is the rate at which subscribers discontinue doing business with a company within a certain period of time. Although there are several ways to calculate churn, let’s use a basic formula and assume that at the start of the month you had 250 subscribers. If at the end of the same time period you had 235 subscribers, your churn rate is 0.6% (250 – 235 = 15 / 250 = 0.6%).

Now that we’ve covered the primary recurring revenue pricing models and key metrics, let’s take a closer look at how these metrics can affect forecasting annual recurring revenue, and help you achieve your short- and long-term goals.

Forecasting Annual Recurring Revenue – Put It to Work

As a measure of the financial health of your subscription business, knowing the amount of revenue you can reasonably expect to receive is critical to make insightful decisions and maintain a positive cash flow. The following scenarios use some of the above metrics to see how they can help you determine the changes necessary to keep your company profitable.

Scenario 1

After calculating CAC, the figure shows an upward trend. While this figure doesn’t solely determine your success, it is an indicator that you may need to make some changes. Use this figure as a guide in determining whether you need to lower your customer acquisition costs, and if so what measures can you put in place to decrease CAC. Remember, CAC needs to be significantly less than CLV, however, you don’t want to underspend and jeopardize your CLV.

Scenario 2

At the heart of the overall financial health of your organization, CLV provides the information needed to determine how much you should spend acquiring new customers (CAC). It can uncover the potential effects of customer churn, and how changes to products or services can play a key role in either increasing or decreasing the revenue received from customers.

Scenario 3

No one likes to think about it, but customer churn does and will happen. What you don’t want is to be caught off guard by an influx in churn. Keeping an eye on this figure helps you to know when churn is on the rise so that you can determine what’s causing it, and take proactive action to stop the flow.

As you can see, tracking these metrics will enable you to proactively make informed decisions to ensure your annual recurring revenue forecasts are accurate, stable and growing.

Keep Recurring Revenue Streams Flowing

Making the decision to adopt a recurring revenue business model is an attractive choice for companies and customers alike. When properly implemented, you’ll benefit from increased revenue, decreased cash flow, and improved profitability. However, this model requires an agile approach to billing. Legacy billing systems simply don’t provide the support needed for today’s recurring revenue pricing models. You need the ability to quickly and efficiently bring innovative recurring revenue pricing models to market. This requires a cloud-based billing platform that supports any combination of recurring revenue pricing models – on a single platform. BillingPlatform – an agile cloud-based billing platform – was designed to give you the flexibility to manage dynamic pricing for one-time charges, usage, tier, subscription, overages, minimum commitment… and more. A member of our team is ready to show you more today!

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