Annual Recurring Revenue (ARR)
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Imagine being able to predict your income with remarkable accuracy. ARR is a key metric for subscription-based businesses to make smarter and more informed decisions.
ARR helps you see beyond one-time sales, clearly showing your stable, predictable income stream. This helps you plan for the future, make smart investments, and achieve sustainable growth.
In this blog, we are going to cover
Let’s get started with the basics.
What is ARR (Annual Recurring Revenue)?
ARR, or Annual Recurring Revenue, is a key metric businesses use to understand their predictable and recurring income.
It represents the annualized value of all the recurring revenue a company expects to receive from its customers within a year. This can come from subscriptions, contracts, or any other arrangement where payments are made at regular intervals.
ARR is particularly relevant for businesses that operate on a subscription model, where customers pay a regular fee for continued access to a product or service.
Why is ARR important?
Annual recurring revenue holds several significant benefits for businesses, particularly those with subscription revenue models.
Some of these are discussed as follows:
Predictable revenue
ARR helps forecast future revenue more accurately than metrics focusing on one-time sales. This is crucial for business planning, budgeting, and overall financial stability.
Business valuation
ARR is a key factor in determining the valuation of a subscription-based business. Investors and potential acquirers often use ARR as a metric to assess the health and potential growth of a company.
Financial performance
ARR provides a clear picture of a company’s financial performance over time. Consistent growth in ARR indicates a healthy and sustainable business model.
Customer retention and expansion
ARR considers new customer acquisitions and expanding or contracting existing customer subscriptions. It reflects not only the ability to acquire new customers but also the ability to retain and upsell existing ones.
Decision-making tool
Analyzing various components of ARR can guide strategic decisions. For instance, seeing which customer segments contribute most to ARR growth suggests where to focus marketing efforts.
Analyzing churn within ARR can help identify areas for customer retention improvement.
Cost & efficiency improvement
Knowing your ARR allows for better resource allocation. You can plan staffing needs, marketing budgets, and product development based on your predictable income, leading to increased efficiency and cost-effectiveness.
Difference between ARR & MRR
Annual Recurring Revenue (ARR) and Monthly Recurring Revenue (MRR) are key financial metrics crucial for businesses operating on subscription models. These metrics provide insights into the predictability and sustainability of revenue generated from recurring subscriptions.
But there is a substantial difference between both. Let’s check that out.
| Criteria | ARR (Annual Recurring Revenue) | MRR (Monthly Recurring Revenue) |
| Time Frame | Represents revenue over a 12-month period | Represents revenue on a monthly basis |
| Calculation | ARR = MRR * 12 | MRR is the sum of all recurring revenue in a month |
| Usage | Often used for strategic planning, business valuation, and financial reporting | Frequently used for monitoring short-term revenue trends, identifying patterns, and assessing performance |
| Stability | Offers a stable and predictable view of revenue over a longer period | Reflects revenue fluctuations on a month-to-month basis |
| Investor Interest | Attracts investors interested in long-term financial health and growth | Attracts investors interested in short-term revenue performance and trends |
| Business Decision-Making | Influences strategic decisions, product development, and long-term planning | Guides operational decisions, marketing strategies, and short-term goals |
| Metrics Related | Connected to metrics like Customer Lifetime Value (CLV), Churn Rate, and Customer Acquisition Cost (CAC) | Connected to metrics like Customer Churn, Expansion MRR, and Net MRR Growth |
Both metrics are important for businesses operating on a subscription model, offering insights into different aspects of financial performance.
How to calculate ARR?
Depending on how your subscription model and contracts are structured, there are a couple of ways to calculate ARR.
The two most common methods:
Using MRR (Monthly Recurring Revenue)
This method is ideal if you bill your customers on a monthly basis. Here’s the formula:
| ARR = MRR X 12 |
MRR=Number of Subscribers×Monthly Subscription Fee
Example:
Suppose a software-as-a-service (SaaS) company offers a subscription plan for its cloud-based project management tool. The company charges $1,000 per month for each subscription.
In this example, let’s assume the company has 50 subscribers, each paying $1,000 per month.
MRR = Number of Subscribers × Monthly Subscription Fee
MRR = 50×$1,000 = $50,000
Therefore, the Monthly Recurring Revenue (MRR) is $50,000.
Multiply MRR by 12 to get ARR
ARR = MRR×12
ARR = $50,000×12 = $600,000
Therefore, the Annual Recurring Revenue (ARR) for this SaaS company would be $600,000.
Using annual contract value
If you have annual contracts with customers, you can simply sum up the total annual value of all your contracts and divide by the number of years in the contract term.
| ARR = Total annual contract value / Number of years in contract term |
Example
You have a cloud storage service with three annual plans:
- Basic: $10/month
- Pro: $25/month
- Enterprise: $50/month
You have 50 Basic, 20 Pro, and 10 Enterprise customers.
Here’s a simplified way to calculate your ARR:
- Find the annual value per customer for each plan: Multiply the monthly price by 12 (months in a year).
- Basic: $10/month * 12 months = $120/year
- Pro: $25/month * 12 months = $300/year
- Enterprise: $50/month * 12 months = $600/year
- Multiply the annual value by the number of customers for each plan:
- Basic: $120/year * 50 customers = $6,000
- Pro: $300/year * 20 customers = $6,000
- Enterprise: $600/year * 10 customers = $6,000
- Add the annual value from all plans: $6,000 + $6,000 + $6,000 = $18,000
Therefore, your ARR is $18,000.
Elements to be included & excluded in ARR calculation
While calculating Annual Recurring Revenue (ARR), certain elements are included while others are excluded to provide a clear and consistent representation of the predictable and recurring revenue from subscription-based services.
Below are the inclusions you need to include while calculating ARR:
Recurring subscription fees
The primary component of ARR includes the fees charged to customers on a regular and recurring basis for access to the product or service.
Usage-based charges
If applicable, any additional charges based on the customer’s usage, such as data storage fees, transaction fees, etc.
Add-ons and upgrades
Revenue is generated from additional features, add-ons, or upgrades that customers choose to include in their subscriptions.
Downgrade revenue
Revenue is contracted when customers move to a lower-tier subscription plan or reduce their usage. This includes the revenue associated with downgraded plans.
Here are some exclusions you need to include while calculating ARR
One-time fees & non-recurring revenue
Fees that are charged only once, such as setup fees, onboarding fees, or any other non-recurring charges. These are excluded as they don’t represent recurring revenue.
Refunds and credits
Refunds issued to customers or credits given for service interruptions are typically subtracted from the calculation.
Taxes
Taxes collected from customers, such as sales tax or value-added tax, are usually excluded from ARR.
Examples for calculating ARR
Let’s go through a few examples to illustrate how Annual Recurring Revenue (ARR) is calculated in different scenarios.
Example 1: Simple Subscription Model
Suppose a streaming service charges $15 per month for its premium subscription. If they have 1,000 subscribers, the Monthly Recurring Revenue (MRR) would be:
MRR=Number of Subscribers×Monthly Subscription Fee
MRR=1,000×$15=$15,000
Now, to calculate ARR:
ARR=MRR×12
ARR=$15,000×12=$180,000
So, the ARR for this streaming service is $180,000.
Example 2: Including Add-ons and Upgrades
Consider a software company offering a base subscription at $50 per month and additional premium features for $20 per month. If they have 500 subscribers on the base plan and 200 subscribers with premium features, the MRR would be:
MRR=(500×$50)+(200×($50+$20))
MRR=$25,000+$14,000=$39,000
The ARR would then be:
ARR=MRR×12
ARR=$39,000×12=$468,000
So, the ARR for this software company is $468,000.
Example 3: Accounting for Downgrades
Imagine a subscription box service that offers different plans, with the premium plan priced at $100 per month. If they start the year with 300 premium subscribers and experience 50 downgrades to a lower-tier plan at $50 per month, the MRR would be:
MRR=(250×$100)+(50×$50)
MRR=$25,000+$2,500=$27,500
The ARR calculation would be:
ARR=MRR×12
ARR=$27,500×12=$330,000
So, the ARR for this subscription box service is $330,000.
Example 4: Membership with annual contract
Imagine you run a gym with annual membership fees of $300 and 1000 members with annual membership. Imagine you have an 80% renewal rate.
Number of renewing members = 1,000members×80%=800members
ARR=Annual Membership Fee per Member×Number of Renewing Members
ARR=$300 × 800 = $240,000
So, the ARR for the annual contract is $240,000
How to increase ARR?
In today’s competitive business landscape, achieving sustainable growth and financial stability is paramount for organizations across industries. As discussed, one of the key metrics used to measure this growth and stability for subscription-based businesses is Annual Recurring Revenue (ARR).
Below are some of the ways by which you can increase your ARR.
Focus on customer acquisition & retention
You should enhance your marketing and sales efforts to reach a wider audience and generate more leads.
Try to reduce your churn rate by analyzing why your customers are leaving and address those pain points. Improve customer service, offer loyalty programs, and provide valuable resources to keep customers engaged and satisfied.
When possible, encourage your customers to upgrade their plans or add complementary products or services.
Improve Operational Efficiency
Make it easy and convenient for customers to pay their subscriptions. Offer automatic payments and multiple payment options.
Analyze your marketing and sales funnel to identify any bottlenecks that delay customer acquisition and conversion.
Product expansion
You can develop new product features that would attract existing customers to upgrade or subscribe to additional services.
You can explore partnership options with other platforms to provide a more comprehensive solution.
Optimize your pricing strategy
Review your pricing tiers so that they accurately reflect the value you offer and align with your target market’s expectations.
If possible, implement dynamic pricing plans based on usage or value-based pricing that reflects the specific benefits received by each customer.
Leverage technology & automation
Make use of marketing automation tools to ease the repetitive tasks. This would free up resources for more strategic efforts.
Implement CRM software where you can gain insights into customers’ behavior and preferences.
It’s important to remember that while ARR reflects your predictable income stream, it is important to gain a complete understanding of your financial health. For that, you need to consider your operating expenses (OpEx). OpEx refers to the ongoing costs associated with running your business, such as employee salaries, marketing expenses, rent, and technology costs.
ARR for Xaas & subscription model
For XaaS (Everything-as-a-Service) and subscription-based businesses, ARR (Annual Recurring Revenue) forecasts stable income allowing better planning and resource allocation. It shows the financial health and growth potential, making your business attractive to investors.
ARR provides the most precise way to track relationship changes, whether it’s gaining or losing customers, renewing subscriptions, upgrading services, or downgrading plans.
Takeaway from ARR
Understanding ARR (Annual Recurring Revenue) is crucial for any XaaS or subscription-based business, it is more than just a financial metric.
Other than the points mentioned above, ARR can also help with:
- Guide with product development, focusing on features that encourage upgrades and subscriptions.
- Continuously analyze ARR and related metrics to make informed decisions for growth and optimization.
- Comparing your ARR with industry standards reveals areas for improvement and helps you stay ahead of the curve.
Remember, ARR is a metric that requires continuous monitoring and analysis. You can confidently navigate the subscription landscape by actively using it to guide your strategies and adjust your approach. This helps you outshine competitors and set a path for long-term success.