What is Annual Recurring Revenue (ARR)
Annual Recurring Revenue, or ARR, is a subscription economy metric that shows the money that comes in every year for the life of a subscription (or contract). More specifically, ARR is the value of the recurring revenue of a business’s term subscriptions normalized for a single calendar year.
For example, if your subscriber purchases a two-year subscription for $12,000, the ARR would be $6,000 for each year. ARR is predictable revenue that can be counted on every year.
Why is ARR important for a subscription business
ARR is a good measurement of the health of a subscription business. Because ARR is the amount of revenue that a company expects to repeat, it enables measurement of company progress and prediction of future growth. It’s also a useful metric for measuring momentum in areas such as new sales, renewals, and upgrades - and lost off momentum in downgrades and lost customers.
ARR is particularly useful as a metric to:
Clarify company health. ARR measures company performance in specific areas, showing where revenue is growing or being lost, and why. Knowing your ARR can help you make better decisions regarding employee assessment, compensation, operational planning, and financing to improve the bottom line and help increase company efficiency.
Increase revenue. Tracking relationship changes provides insight into what customers want and need, and helps to promote cross-selling and up-selling which leads to increased revenue.
Forecast revenue. Planning the duration and cost of different subscriptions helps forecast revenue from potential clients. Tracking the value of renewals and the cost of lost customers (i.e. churn) helps businesses manage expenses more precisely and maintain cash resources.
Retain top talent. Monitoring ARR encourages a business to focus on individual sales territories to determine what’s working and what needs changing. Compensation commensurate with productive job performance results in less turnover and cuts new employee training costs.
Attract investors. Investors prefer the contractually-obligated revenue, predictable sales models, and accurate revenue forecasting of the subscription economy over one-time sales. Subscription businesses with ARR can thrive because owners can sell predictably and systematically.
ARR for SaaS and the Subscription Economy
The subscription economy is based on relationships - not one-time sales - but these relationships constantly change and get reevaluated. ARR is the most accurate way to measure relationship changes as indicated by new or lost customers, renewals, upgrades, or downgrades. All of these factors affect revenue but cannot be measured with traditional accounting methods, specifically GAAP (Generally Accepted Accounting Principles).
How to Calculate Annual Recurring Revenue
ARR calculations can include the following:
Revenue from new and renewing customers
Upgrades and add-ons
Losses from downgrades and lost customers
To calculate ARR, divide the total contract value by the number of relative years. For example, if a customer signs a four-year contract for $4000, divide $4000 (contract cost) by four (number of years) for an ARR of $1000/year. If a customer declines to renew a $6000 contract over two years, divide $6000 (contract cost) by two (number of years) for an ARR decrease of $3000.
ARR only includes fixed contract fees, not one time charges. Rather, single charges (or, variable revenue) should be accounted for separately. If any extra, non-subscription charges are lumped into ARR, accuracy is lost in your calculations.
Billing cycles don’t affect ARR, as long as the term of the subscription is a year or more and is recorded the same regardless of how payments are structured.
ARR vs MRR
ARR should be calculated for annual terms - with a one-year minimum. Subscriptions that have terms that are less than one year shouldn’t be recorded in ARR. These types of short-term contracts often allow for subscription cancellation within 30 days. If these subscriptions were calculated as ARR, that would be inaccurate. Instead, shorter term subscriptions should be calculated as monthly recurring revenue (MRR).
Download our free e-book to learn more about annual recurring revenue today!