Annual recurring revenue (ARR) refers to the normalized annual revenue that a company expects to receive from its subscribers in return for products and services provided. In other words, it’s the predictable and recurring revenue generated by customers within a one-year period. Annual recurring revenue is not only the annualized version of monthly recurring revenue (MRR), it also represents how much recurring revenue the business can expect based on yearly subscriptions.
Primarily used by subscription-based software as a service (SaaS) companies, ARR is one of the key metrics used to:
- Increase revenue through cross-sell and up-sell initiatives.
- Forecast revenue by using the subscription duration and revenue that will be generated during the subscription time.
- Gain a better understanding of the financial health of the business.
- Plan for new features and functionality using acquired knowledge of what customers desire.
- Develop actionable growth strategies by leveraging ARR’s predictable sales models and accurate revenue forecasting.
Annual recurring revenue provides a high-level view of the financial health of the business and helps in determining the rate at which the business needs to grow to remain profitable. With that in mind, let’s dig a bit deeper into when the ARR model should and shouldn’t be used, why ARR is important, the differences between ARR, MRR, and total revenue, calculating ARR, common calculation and interpretation mistakes, and how to increase annual recurring revenue.
Should Your Business Use the Annual Recurring Revenue Model?
Best suited for companies that sign the majority of their customers to subscription terms of at least one year, this revenue model is a favorite of the growing number of everything as a service (aka anything as a service) (XaaS) businesses such as SaaS, platform as a service (PaaS), infrastructure as a service (IaaS), and workplace as a service (WaaS) organizations. For these types of companies, ARR provides the most accurate way to measure new customers, customer churn, renewals, upgrades, and downgrades.
What if your business offers monthly subscriptions in addition to annual subscriptions? While you’re able to calculate ARR by projecting each customer’s monthly charge out for the year, this figure is prone to inaccuracies as customers can end their subscriptions at the end of any month. For companies that offer annual and monthly subscriptions, it is recommended that ARR and MRR are used to calculate revenue – depending on the duration of the subscription.
The Importance of Annual Recurring Revenue
Business metrics are powerful tools; however, they need to be gathered, accurately calculated, correctly understood, and used in the right context.
As one of the key indicators that provide metrics to the overall health and performance of the business, it provides insights gathered from the data that comprises annual recurring revenue such as annual recurring revenue from new customers, customer subscription renewals, incremental increases from upgrades, add-ons, etc., losses from downgrades, cancellations (churn), etc.
The long-term snapshot provided by ARR enables SaaS businesses to:
Forecast revenue
As one of ARR’s primary and essential functions, ARR enables businesses to accurately predict future revenue. By using ARR as the baseline, businesses can take other factors into consideration such as churn rate, customer acquisition goals, potential price changes, planned packaging changes, etc. to paint a reasonably accurate picture of what future revenue will look like.
Track revenue from customer segments
The various components of the ARR model provides the ability to determine and track which customer segments provide the most revenue, and which ones provide the least.
Improve subscription business models
Calculating ARR helps reveal your business model’s strengths and weaknesses, providing the opportunity to make informed decisions. For instance, ARR allows businesses to better understand areas of opportunity already present in the current business model. This information can then be used to take appropriate actions such as prioritizing up-sells or cross-sells, focusing on customer acquisitions, reducing customer acquisition costs, etc.
Determine growth potential
The predictability and stability of annual recurring revenue makes it one of the most tangible metrics to determine a company’s future growth potential or decline rate. By comparing year-over-year ARR, organizations can establish how growth compounds over time. For early-stage SaaS companies, it’s a key metric investors and other stakeholders use to gauge the business’s overall performance. Additionally, investor’s use the predictability and stability of ARR to compare the company’s performance against its peers, as well as to compare it with its own performance over time.
ARR vs. MRR and ARR vs. Total Revenue: What’s the Differences?
While the annual recurring revenue and monthly recurring revenue models share many similarities, ARR and total revenue contain significant differences.
ARR vs. MRR
As the term implies, ARR is the annualized version of MRR, However, there are subtle differences. ARR represents recurring revenue on a macroscale and is a valuation metric. MRR represents the company’s recurring revenue on a microscale, is an operating metric, and can fluctuate considerably due the varying number of days in a month.
ARR vs. Total Revenue
While ARR measures subscription-based revenue only, total revenue considers all income received by the organization. For instance, one-time fees for implementation, consulting, and training, as well as offerings that are not a part of the subscription business shouldn’t be considered when calculating annual recurring revenue.
How to Calculate Annual Recurring Revenue
When calculating ARR there are numerous factors to consider like your pricing strategy, business model complexity, and others. However, the basic ARR calculation is quite simple. To start, the calculation requires the total monetary figures for the following:
- Customer acquisitions and renewals: Total accrued revenue received from new subscribers and subscription renewals.
- Upgrades: Typically resulting from up-sell/cross-sell campaigns that increase the annual subscription price on a recurring basis.
- Add-ons: Purchases such as add-ons and features that increase the annual subscription price on a recurring basis.
- Downgrades: Downgrades resulting from subscribers that change their subscription plan to one at a lower recurring annual subscription price.
- Customer churn: Customers that cancel their subscriptions. This figure also contributes to the company’s overall churn rate.
It’s important to remember that one-time or variable fees should be excluded from the ARR calculation.
ARR Calculation
ARR = (total revenue of annual subscriptions + total revenue generated from add-ons and upgrades) – (total revenue lost from cancellations and downgrades).
Simple Calculations for a SaaS Company
Let’s look at a straightforward scenario of calculating ARR for a multi-year subscription contract. Consider a SaaS company with one customer who purchased a three-year subscription for a total amount of $15,000. To determine the ARR, simply divide the total amount of the contract by the length of the contract.
$15,000 / 3 = $5,000 ARR
The above provides the basis for calculating annual recurring revenue, however other factors can come into play such as varying contract lengths, diverse pricing schemes, product bundles, discounts, etc. What initially appears straightforward can quickly become problematic, which often leads to calculation errors, as well as inaccurate interpretations.
Common Annual Recurring Revenue Calculation and Interpretation Mistakes
While ARR calculation and interpretation errors vary, here are the four most common.
1) Including one-time transactions
Imagine you collected a one-time payment of $250 for a service. While the additional $250 gives your cash flow a boost, it can’t be considered in your ARR since the single purchase and payment is not recurring.
2) Excluding discounts or promotions
Let’s assume that you offer a $500 discount on a certain product. Subscribers taking advantage of the discount need to be accounted for in your annual recurring revenue calculations. Say the typical annual cost of a product is $4,500. Subscribers making purchases during the promotional period are charged $4,000 instead of $4,500.
3) Including delinquent payments
It happens…customers don’t always pay on time. While you may have high expectations of receiving the payment, late payments can’t be included in your annual recurring revenue. The best way to handle payment delinquencies is to create a separate category and deduct the corresponding values from your ARR accordingly.
4) Including trials
Providing a free trial doesn’t guarantee that the prospect will become a paying subscriber and for this reason shouldn’t be included in ARR calculations. For those that do become subscribers, the trial period can’t be included in your annual recurring revenue.
Additionally, annual recurring revenue calculations are often factored into financial statements they shouldn’t be, leading to misinformation. Generally, recurring revenue should only be reflected in your income or P&L statements.
What it Takes to Increase Annual Recurring Revenue
For subscription-based companies, building and maintaining profitability relies on customer retention. Aside from acquiring more subscribers, here are a few strategies to take into consideration to boost your ARR.
- Keep customer acquisition costs (CAC) to a minimum: By comparing recurring revenue with CAC, you’re able to determine other financial considerations such as CAC marketing spend. This way you can either reduce CAC costs or find ways to use the money more effectively.
- Increase customer lifetime value (CLV): This comes down to customer retention, and the most reliable way to increase ARR is by reducing churn. Ways to accomplish this include personalizing the customer experience, creating an internal team focused on customer retention, and targeting potential customers that your products and services will help in resolving their challenges.
- Incentivize customers: Entice customers to subscribe to a higher price subscription tier that contains sought-after upgrades, features, add-ons, etc.
Aside from the above, there are some long-term initiatives like cross-selling and up-selling and increasing your subscription price points. Increasing price points is especially important if research determines that your pricing is less than your competitors.
Give Your Annual Recurring Revenue a Boost
Keeping your subscription business profitable requires an accurate view of its financial health. However, managing your recurring revenue business isn’t easy, especially as your business grows. With growth comes high volumes of financial data and recurring payment transactions that can become daunting and error-prone, especially if handled manually or with a legacy billing system.
To stay on top of your annual recurring revenue processes and gain an accurate view of your financial health, you need to streamline and automate the processes. BillingPlatform provides the automation needed to gain a complete view of your financial standing so that you can run your subscription-based business with greater efficiency and accuracy. With us you get the power needed to enable any kind of billing model and support even the most complex recurring revenue relationships. Let BillingPlatform answer the questions you’ve been asking.
